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The Most Important Market No One Is Watching


You can't have stronger nominal growth and lower interest rates. When the market begins to discount may be anyone's guess, but it will most certainly show up in the bond market.


I didn't make it in mortgages, but I was given the opportunity to work for one of the best bond trading firms on the street, Greenwich Capital Markets, where I was an assistant in the portfolio strategies group. Though at Greenwich I wasn't getting coffee, making copies, and cold calling like at Bear Stearns in Atlanta, I was picking up the phone and trading. And this wasn't odd lot agencies and munis, this was block size Treasury trading on the wire.

One of my main responsibilities was executing interest rate futures trades at the CBOT and CME. I traded a lot of bond futures during that time and I soon realized why Shoemaker called it the contract. The 10-year futures ("TY") is what you trade when you need to hedge interest rate risk such as mortgage convexity hedging, the contract ("US") is what you trade when you want to speculate.

There are legions of self-proclaimed "macro" strategists and hedge fund managers who cite and trade the (TLT) bond ETF. It's one thing for a retail investor to trade TLT, but there is no self-respecting bond strategist or fund manager that has even ever uttered the letters TLT. Trust me you will never see CRT's David Ader cite TLT and you won't see Paul Tudor Jones trading it. If you want to know what the bond market is doing you have to watch the contract.

Friday the contract did its thing. Watching the price action pre and post NFP, there was no disputing which way the speculators were leaning, and when they covered on the gap, there was no bid behind. Casual market observers like the New York Times brush off the price action as irrelevant to the story, but I am here to tell you it's the whole story.

Since the miserable June NFP that only saw 45K jobs added, the contract (Dec now front month) has been confined to a range with the big pivot at 150-00 which is the same level that was tested in Thursday and Friday's intense volatility. This is not a random coincidence. The market is battling in here.

The volume in the pits on Friday in both the TY and US of 1.45mm and 503m contracts respectively nearly turned over their total open interest. The notional dollar value of the volume represents $195b. Can they really control the entire market just buying a couple billion in cash a day? Regardless Friday demonstrated that Ben Bernanke faces a potentially dangerous bond market paradox.

Friday the action in the yield curve told the whole story. The belly, 5-year and 7-year led the performance finishing better by 3bps and the 5-year/30-year spread finished 6bps steeper on the day. The steepening bias in the curve was a clear message that the bond market is preparing for a higher inflationary discount as the result of QE III.
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