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Monetary Policy Chaos: Sell First, Bid Last, Ask Questions Later


It doesn't matter what the Fed thinks; it only matters what the market thinks.

I realize that it's still summer, but this bond market participant is suffering from severe irrelevant information sensory overload. I am beginning to wonder if anyone really knows what they are doing or how the market works anymore. It seems like people are completely lost and just making it up as they go along. The Fed has been fiddling with markets for so long that the market's ecosystem has been compromised. The old rules of market discounts no longer apply, and nobody knows what the new rules are.

The obsession with tapering QE is beyond absurd and indicative of this policy saturation. The dealer community has been hypnotized by the duration of QE and can't seem to break out of the trance. Treasury and mortgage-backed security (or MBS) yields are up 100bps across the curve, yet strategists are still trying to figure out how the Fed might calibrate purchases.

In case you have just joined us, the bond market doesn't care about how much the Fed is buying. Between Treasuries and MBSs, the daily average volume is over $800 billion. Who cares if the Fed cuts its $4 billion in daily purchases by $500 million? Dealers are splitting hairs over $5 billion to $10 billion per month of tapering in a market that trades $800 billion per day. It's irrelevant.

However, what's not irrelevant is the policy chaos and the bond market's response to the uncertainty.

Case in point: There was perhaps the most important market development last week that no one even noticed. On Monday, the spot rate on 12-month LIBOR fell to the lowest level of the cycle at 0.6646%. This was the same week that saw the Eurodollar futures curve for 3-month LIBOR blow out to historic steepness. This is not how it's supposed to work. What is causing this mass divergence?

12-Month LIBOR Vs. Eurodollar Curve

As equity investors think in terms of price multiple, bond traders think in terms of spread. The term structure of the yield curve is the spread benchmark; typically these spreads have been a function of the bond market's inflation risk premium for the given term.

Bond investors will trade these spreads via butterflies (i.e. buying a 5-year and selling a 2-year and 10-year) and outright curve trades (i.e. buying 30-years and selling 10-years). Most of these trades are duration neutral, which is a way of taking out the directionality of the position, and are executed based on relative value.

5-Year/10-Year Vs. Eurodollar Curve

Currently, there are spreads across the interest rate complex that are at historically steep levels. In the Eurodollar curve, the spread between the 3-month LIBOR 4-year and 2-year futures is 216bps. Also in the belly of the Treasury curve, the spread between the 5-year and 10-year has steepened out to 125bps, near the widest levels in history, which were hit in June 2011 as inflation premiums peaked when QE2 was winding down. Bond market participants look at these spreads in the backdrop of benign inflation and know something isn't right.

If there was demand for money, the spot rate on 12-month LIBOR would be rising; if the market was discounting Fed tightening, the curve should be flattening as rates rise. What we have here is a bear steepener, which is theoretically a product of rapidly rising inflation expectations.

Bear steepeners are extremely rare, and I would venture to guess there are not many bond market participants who have ever witnessed one, much less tried to trade it. What makes this bear steepener even more bizarre is that real yields (TIPS) are rising more than nominals, which is lowering inflation breakeven spreads across the curve. In the nominal curve, you have inflation premiums steepening, while in the real curve, they are flattening. This is curious divergence.

5-Year/10-Year Vs. 10-Year Breakeven Inflation

What I believe is happening is a rapid repricing of term structure risk premiums due to monetary policy chaos.

This curve steepening is a reflection of mass confusion among bond market participants. It is a function of a widespread reduction to interest rate risk that is irrespective of the discount of growth and inflation. One of the more glaring examples of this reduction in risk was the revelation that hedge fund titan Bridgewater blew out of its exposure to both nominal and real interest rates. As reported by Bloomberg:
Bridgewater, citing months of study, said it had underestimated the interest-rate sensitivity of various assets in its All Weather fund and was taking steps to mitigate the risk, according to clients who listened to or read a transcript of the June 24 call. By the end of the month, the Westport, Connecticut-based firm had sold off $37 billion of All Weather's most rate-sensitive assets, Treasuries and inflation-linked bonds, according to fund documents and data provided by investors.

These guys are no dummies, and I would be willing to bet their models would have picked up on an increase in economic activity or rising inflation pressures that would have ordinarily been a catalyst for rising interest rates. The more likely explanation is that they got caught off guard by the Fed's abrupt policy shift.
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