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Welcome to the Dark Side of QE: The Yield Curve Adjustment Process


The Bernanke disciples are claiming QE victory with stocks refusing to go down, however his metrics of growth and inflation are decelerating to near the lows of the recovery.

On Thursday the Treasury auctioned off the 30-year bond in what appeared to be strong buy-side demand. Indirect bidders who represent foreign central banks took down 39%, of which was above recent levels of recent foreign participation. As soon as the results hit the tape, the USDJPY started spiking on what appeared to be Japanese accounts swapping into dollars to finance their 30-year allocations. That yen-selling pushed USDJPY above the psychological 100 level which seemed to trigger some buy stops as the currency pair continued to rally quickly, hitting the 100.50 level.

USDJPY 2-Day Tick

The spike through 100 turned what was a strong auction rally in the long end of the curve into an immediate reversal sending yields higher by 5bps into the close. The reversal was swift and you started hearing chatter about cross currency structures that needed to sell Treasuries to hedge the yen weakness, but not much was made of it. Friday we woke to further weakness in bonds as the USDJPY continued higher sending the 10-year up 10bps from Thursday's low.

Apparently the culprit was a carry trade structured product called a Power Reverse Dual Currency Note whereby the issuing Japanese banks were forced to sell Treasuries against the weakening yen, and presumably the 100 level set off a wave of this hedging. So ironically, what was a strong Treasury auction from Japanese accounts triggered a massive sell-off in yen that triggered a massive sell-off in Treasuries.

US Bond Futures 5-Day Tick

Back on January 22, I wrote a piece about the ramifications of the Bank of Japan's new 2.0% inflation target and subsequent volatility it was causing in the FX markets. I posited whether this new monetary regime would trump the Fed's ability to affect US capital market pricing in Are We Witnessing a Tectonic Shift in Which Central Bank Dominates Asset Prices and Risk Premium?:

Today could be a seminal event as we may be witnessing a central bank transfer of power. The Federal Reserve's monetary policy has been dominating asset prices since the era of easy money began in 1998. We've now come full circle. With the introduction of a 2% inflation rate by the Bank of Japan and a subsequent effort to devalue the yen to get it there, we may be witnessing a tectonic shift in which central bank policy dominates asset prices and risk premiums.

The FX market is very deep and liquid. This kind of volatility is significant, and if it continues, it's only a matter of time until it finds its way into the US capital markets.... It's not US economic and earnings growth that will derail this rally in risk. Like in 2008 and in 1998, it's a systemic second or third derivative event that the market cannot discount.

Cue the Power Reverse Dual Currency Note. You can't make this stuff up. If you ever had any questions about whether the Fed had control of the US bond market, Friday was an eerie example of what can go wrong. What was even scarier about last week's FX and bond market volatility is that some esoteric foreign structured product that no one has ever heard of showed how fragile and susceptible the bond market has become.

You would think this type of bond market volatility that is completely driven by something the Fed can't control would scare the bejesus out of Ben Bernanke and his faithful disciples, but ironically this week with stocks rallying to new all-time highs and rumors of a Fed exit, they were instead taking a bit of a victory lap. It seems that because stocks won't go down that Bernanke's easy money policy has been vindicated. This sentiment was juxtaposed against anti-Bernanke comments out of prominent hedge fund managers during presentations at this past week's investor conferences.

Business Insider's Joe Weisenthal wrote a piece suggesting hedge fund managers don't understand monetary policy:

One big theme: Bernanke hate. A lot of the big guys HATE him.

If you listen to a lot of old industry veterans, you'll hear a lot of grousing about Bernanke and QE and all that jazz. Basically, they sound like your typical comments section on a blog.

Hedge funds are doing badly in this rising-tide-lifts-all-boats market, and they feel that they would be outperforming if the Fed just let things collapse, and they could swoop in when prices "clear."

Matthew O'Brien of the Atlantic followed up, defending Bernanke, suggesting that hedge funds are underperforming because they don't get Keynes.

The biggest mistake an investor can make today is not realizing it's Keynes' world, and we're all just living in it. Now, in normal times, there's a straightforward relationship between money and prices: the more of the former, the higher the latter. (Indeed, Keynes wrote about this before he invented Keynesian economics). But these aren't normal times -- interest rates are stuck at zero. When cash and bonds are close substitutes -- both yield nothing -- printing money won't increase inflation. It won't do anything.

This hedge fund ridicule misses the point. As I wrote in June last year in Trading the Wrong Playbook Bubble, hedge funds aren't underperforming because they don't get economics, it's because they are applying valuation models to a market that can't be valued:

By manipulating the yield curve to generate negative interest rates, Fed policy has taken the discount out of the discount rate and thus removed the ability for markets to correctly price assets. Fed policy has essentially turned all assets into commodities subject not to valuation but simply the supply and demand for the securities.

The by-product of this Fed policy has produced what I have characterized as the wrong playbook bubble.

At the same time that the Fed was taking the discount out of the discount rate, we saw an explosion of financial analysts, investment bankers, and so-called alpha-generating hedge fund managers all using the same playbook based on valuation models. So while the Fed was making valuation irrelevant, more and more investors were relying on and utilizing the same valuation models to make capital allocation decisions.

By explicitly trying to manipulate the yield curve the Fed has convinced market participants (hedge funds) that valuation is irrelevant. The 10-year yield is the benchmark pricing mechanism for every asset on the planet. The problem hedge fund managers have with QE is not that they don't like higher asset prices, it's that they don't know how to price assets.
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