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The Bond Market's China Syndrome


We are blaming Europe for our current economic problems, but in reality they are doing us a favor by providing a blueprint for how a bond market meltdown can unfold.

MINYANVILLE ORIGINAL This past week we saw potentially one of the most important macro events of the year yet with the exception of a mention by Minyanville's own Michael Sedacca it was given scant attention by the financial media. No I'm not talking about the nonfarm payrolls, the unemployment rate, or the 20+ handle rally in the S&P 500 (^GSPC). I'm not even talking about the FOMC and ECB meetings. I am not talking about any earnings data. Nor am I talking about news out of Europe or China. I'm talking about one simple data point out of Chicago.

Wednesday's FOMC meeting policy release hit the tape with a big fat thud keeping the status quo and offering no hints of any new initiative:
The Committee will closely monitor incoming information on economic and financial developments and will provide additional accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.

Thanks, folks, but we already knew that. Nevertheless, the various pundits, economists, and strategists all chimed in that they were leaving the door open to a September launch of some sort of QE III and that we would likely hear more about the policy options at the Jackson Hole Fed Symposium coming at the end of August.

In 2010, Ben Bernanke used the Jackson Hole summit to telegraph the launch of QE II, and there is an interesting parallel between now and then that should be noted. To get an understanding of what led the Fed to launch QE II, you must recall the backdrop of events during the summer. The equity market, still fragile from the 2008 crisis, had been recovering, but started to crack in April as QE I ended at the end of March. Then the markets were hit with the double whammy of Greece and the Gulf of Mexico BP (BP) well disaster.

In April 2010 after rallying from the March 2009 666 crisis low, the S&P topped at 1220, but more importantly the 10-year yield also topped at 4.00%. The following months into the summer would see the S&P fall to a low of 1010 in early July with a corresponding move in the bond market sending the 10-year to 3.00%.

Despite the market responses to what were largely headline events, the economic data was holding up pretty well. Between March and July the economy created 600K private sector jobs, ISM manufacturing was running in the high 50s and nominal GDP was growing north of 4% all near recovery highs. Stocks actually found support in July and started to grind out of the hole but bond yields continued to fall and in August just prior to the Jackson Hole speech the 10-year had reached the 2.50% area matching the lows seen during the depths of the financial crisis in 2008.

At 4.00% the 10-year was trading at fair value in line with historical discount of nominal GDP but as it rallied to 150bps below this growth rate the bond market was sending a very loud message to the Fed that deflation risk was rising. Or was it?

With the 10-year at 4.00% in the spring of 2010, the large speculators were heavily short the 10-year Treasury futures contract (IEF) and the flight-to-quality bid that resulted from the Greece and Gulf of Mexico double debacles ignited what I believe was a spectacular short squeeze. Between April and August the large spec went from short over 250m contracts ($25b) to basically flat as price rallied from a 115 handle to over 125. The Fed saw this move as rising deflationary risk but I believe they got head faked and it may be happening again.

In April of this year I posted on my firm's blog that the bond market was set up for a similar move to 2010. In Something's Got to Give:
In 2010 the short squeeze that resulted from the Greece & Gulf of Mexico events eventually spooked the Fed into thinking the market was discounting deflation which prompted them to launch QE II. The bond market was the tail wagging the dog. We could see a similar scenario play out where another squeeze vaults us to new highs on stock market weakness which again prompts more Fed action. It is from here where we would look for a market top and intense reversal.

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