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Bond Market's Memo to the Fed: This Is Not a Misunderstanding, This Is a Blow-Up


By focusing on price movement as a misinterpretation of policy, Fed officials are making it clear they don't understand there's a liquidation going on -- and this is a growing risk factor.

With spreads blowing apart the curve over the past couple of months, this large spec position has come down significantly. With positions virtually flat, you would think much of the trade has been taken off, however there has been some conspicuous activity that may suggest otherwise.

Reportedly there has been heavy put option activity over the past several weeks. This put position would benefit from rising rates and looks to be massive. Eurodollar strip prices are already discounting very high LIBOR rates, so it wouldn't make much sense for banks to be continuing to hedge against even higher interest rates. This position looks to be speculative in nature. If I had to guess, either some very large global macro funds are in dire need of hedging a convergence trade, or it's a speculative position to front-run the unwinding of such a trade. This is not a misunderstanding. This is big money. This is a blow up.

As evidenced by flows and positioning, it looks like this trade is deep and one-sided. While we have seen some carnage, it's not clear what the aftermath will bring or who is going to take the other side. Thanks to unintended consequences of Dodd-Frank, the sell-side will likely sit this one out. That's been evident in the lack of liquidity going into quarter end. With the buy-side having to provide liquidity for their own position, it is not clear where the clearing price is. My guess is it's not in line.

Going into the June FOMC meeting I wrote that it was the most important of Bernanke's tenure. Coming out of that meeting there has no doubt been a big misunderstanding between markets and policy. Bernanke says the bond market misunderstands Fed policy but it's looking more like the Fed misunderstands the bond market. What the Fed doesn't seem to get is that the bond market is making policy irrelevant, and even if they finally figure this out, there's probably nothing they can do about it. The damage has been done.

Misunderstanding or not, the bond market has eliminated a lot of capital in a very short period of time. Leveraged long term investors have been torched and capital deployment has been frozen. This unwind has been about a reduction in long term capital and Bernanke's insistence on vague threshold guidance for QE now make it virtually impossible to put this long term capital back to work. How can an investor have confidence to buy a long term bond? How can a bank have confidence to make a long term loan? The answer is that the risk premium is going significantly higher. In the ensuing months we will no doubt see this how this market adjustment evolves into an economic adjustment.

The untold story about this market episode is the damage on investor psyche. It will be very difficult to make a long term capital allocation decision under this dark cloud of policy uncertainty. Regardless of whether they hold off on tapering or extend guidance on zero percent interest rates, confidence has taken a big hit. That will destroy investment in long duration assets, banking system credit creation, and capital investment. That is something we can all understand.

Twitter: @exantefactor
No positions in stocks mentioned.
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