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The Most Important Market No One Is Watching

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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.

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Operation Twist was balance sheet neutral and focused on the long end of the curve, but presumably QE III will expand the balance sheet. This is where it gets tricky for Bernanke. Unlike Operation Twist, the QE III paradox is that the Fed will be attempting to lower interest rates while making them more negative by engineering higher inflation; i.e., they will be raising the value of bonds while making them worth less.

Bernanke would tell you that QE has been successful in lowering interest rates, but think about it. The 10-year yield didn't fall toward 1.50% until after QE II ended. On June 30, 2011 the 10-year was at 3.15%. It wasn't until he balked at more QE and blew up the risk asset reflation correlation trade did bonds catch the bid. You may also recall that when they launched QE II in November 2010 the 10-year was at 2.50% and over the next four months rose over 100bps as the curve steepened on the inflation discount.

Last Tuesday the US national debt crossed the $16t mark. At the time of this writing it's already $13b higher and moving fast. At the end of August the amount of outstanding Treasury debt was approximately $11.27t vs. $10.0t this time last year and v $6.9t in August 2009. The stock of Treasuries has grown by 63% in three years which is 5x the rate of nominal GDP growth over the same time frame. The supply is growing at an alarming rate and absent the Fed and foreigners, there are no natural investors in US Treasuries, only speculators front running Fed intervention and a blow up in Europe.

You can't discount the influential bid in the bond market from the flight to quality out of Europe. With last week's ECB announcement from Mario Draghi that they are prepared to unleash unlimited bond buying it's a wonder how long this fear bid will last. There has been a material fall in peripheral bond yields, especially in the front end where banks likely own. In addition a favorite proxy for European risk premiums, the EURUSD cross currency basis swap has been rallying and is as tight as it's been since last summer. Since June as the bond market has been battling its range, the 1-year EURUSD basis swap has tightened by 40bps which has more that cut the risk premium in half.

Relying on speculators and a fear bid to keep the curve together while you are inflating the coupon could turn into a dangerous game. It looks like the fear bid could be waning and speculators can turn on a dime. If the trading range that has confined the contract since June breaks to the downside the pressure could be on. In addition to the crucial 150-00 level I have lower pivots of 148-00 and 146-16. These levels should be respected if tested and I would not fade the move from these big pivots in either direction.
No positions in stocks mentioned.
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