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Is US Growth Blowing Out or the QE Carry Trade Blowing Up?


At this point, what matters is not just the direction of bond yields and where they end up. It's what driving the trend.

After scanning through this weekend's financial periodicals there was scant mention of this past week's most important market development that could frame trading for the rest of the year and beyond. And I'm not talking about the S&P 500 (INDEXSP:.INX) closing at a new 5-year high.

On Thursday, December 28, 2012 I provided my thoughts for how the bond market would trade in 2013. It wasn't simply a year-end yield target like most strategists issue, but rather a road map to help investors navigate what I believed would be a tough trading environment. The 30-year long bond was poised to close 2012 right on top of where it closed 2011 at 2.90% and I suggested that investors shouldn't assume this to be the case in 2013. The forecast was predicated on the notion that, despite what many assume to be a market that was being controlled by the Fed, the bond futures contract was responding to technical levels and therefore was exhibiting structure.

The following was stated in A 2013 Bond Market Prognostication: Why a Breakout Appears Likely:

The obvious conclusion for why the long bond yield would be closing the year unchanged is that Federal Reserve policy has been actively holding interest rates artificially low via Operation Twist and quantitative easing.... However, upon further examination, it's my belief that market price is saying something different.

Noting the Fibonacci levels:
It's really remarkable that the famed dead Italian could be playing such a prominent role in the price action of a market that is supposedly being manipulated by the Fed. This tells me that the market has structure -- and despite a consensus assumption that the Fed is in control of interest rates, the bond market is not only trending, but is still on a cyclical mission. This big question for investors is whether this cycle is ending or has more room to run.

Nevertheless, this is the time to leave your bias at the door. The bond market has been consolidating a relatively tight range for six months and has lulled many participants to sleep. I think this thing is wound up and ready to break out. It's unlikely that we will be sitting in this same spot next year; which way we go and where we end up is going to have wide-ranging ramifications for the asset markets and implications for the economy.

On Friday, the long bond settled the week at 2.88% and I felt pretty comfortable that the 2.90% unchanged objective would be met. However, the market had other plans. As you know, on Monday, Dec. 31, as the so-called fiscal cliff was getting resolved, the S&P 500 found support at the key 1400 level and was off to the races, putting pressure on the long end of the curve.

The selling continued Wednesday and on Thursday as we received a stronger than expected ADP private payroll report in front of Friday's highly anticipated employment report. Adding insult to injury was Thursday afternoon's release of hawkish minutes from the December FOMC meeting suggesting there was a broad consensus among committee members that the QE would not extend past 2013. This put even more pressure on the long end and spilled over into the MBS market where current coupons took a beating, seeing yields north of where they were when the Fed targeted the sector in September.

The employment report came in line with expectations and markets settled down, however when the dust settled on Friday afternoon stock prices were staring at new highs with the 10-year and 30-year both up approximately 20 basis points in what was a wild holiday-shortened week.

Perhaps just as important as stocks closing at the highest level since 2007 is that the long end of the curve closed at yields that were above the trading range that had confined the market throughout most of the second half of 2012. Was this already the beginning of the breakout I was looking for just a week earlier?

As you always see with markets at the edge of a breakout, tensions are running high. There is a lot of money in the fixed income market that has been put to work over the past six months and that is now likely underwater. There is also a lot of money that had liquidated out of stocks predicated on higher taxes and general economic and fiscal cliff risks. Both parties sit at home this weekend hearing a lot of I told you so's. Money is no doubt scared, so I would like to try to provide a little perspective and hopefully some guidance on how to interpret price action going forward.

There is no shortage of cause-and-effect interpretations in market price movements, and in my opinion, this is one of the most misunderstood information data points reported by the financial media and punditry. The most cited, of course, is the money flow between bonds and stocks, and in this era of easy money, this has been simply characterized by risk-on or risk-off.

The interpretation of last week's market movement was that because bond prices were falling and stock prices were rising, money was flowing out of bonds and into stocks, or that the trade was risk-on due to anticipation of accelerating US economic growth. As bond yields were breaking out of their range with stocks closing at a new high the larger conclusion was that this potentially signaled a seminal change in investment flows, or as some suggested, the much-anticipated great rotation out of bonds and into stocks was underway. I don't think it's quite that simple.

As I stated last week in regards to bond yields, which way we go and where we end up is going to have wide-ranging ramifications for the asset markets and implications for the economy. At this point it's not just the direction of bond yields and where they end up that matter as much as what is driving the trend. In order to determine the answer investors need to understand whether the move is signaling a breakout in real growth or simply the unwinding of the QE trade.

Back on October 22 in Charting a Course Balancing Open-Ended QE and the QE Asset Reflation Correlation Trade I laid out the potential risks for the eventual unwinding of the QE trade.
Throughout the month of October I have been working off two main themes: 1) that open-ended QE would bring about increased bond market volatility and 2) the consensus QE asset reflation correlation trade should be faded.

Here is where it gets even more interesting in what could define the trade for 2013. Is it possible that both stocks and bonds go down at the same time?

Most investors are looking toward 2012 worried about the results of the election and whether the fiscal cliff gets resolved. These are the known risks. The unknown risk is what I am worried about. To me that is how and when QE comes undone. The big trade in 2013 might not be about the effect of a fiscal policy debacle; it might be about the effect of a monetary policy debacle.

As I thought through how to differentiate whether this was a breakout in growth or the unwinding of a trade, I kept running into the same perplexing observation. Regardless of which trend is unfolding, the leading market indicators will both initially trade in the same manner. If we are witnessing a breakout in real growth, you would expect to see the dollar rally, gold fall, and interest rates rise, as is happening now. However if the QE trade is unwinding, you would also expect the same things to be happening.

A couple differences could be observed in the slope or the yield curve and risk premiums. If growth is accelerating, bond yields should rise in a flattening trend with risk premiums tightening as the economy soaks up excess liquidity thus removing the inflation premium. If the QE trade is unwinding you would expect bond yields to rise in a bear steepening trend with risk premiums widening as implied short USD carry trades reverse.

Thus far the markets are inconclusive. The curve has traded with a steepening bias but risk premiums tightened. In fact as the S&P 500 rallied to close at new 5-year highs and as reported in the FT the average yield on high yield bonds fell below 6% for the first time. When the basic asset markets are giving conflicting signals you must dig a little deeper.

A market that is not typically regarded by most investors for its effect on US risk assets and interest rates yet may actually hold the key to which trend ultimately develops, accelerating growth or QE unwind, is the Japanese yen / US dollar cross. Since Japanese Prime Minister Shinzo Abe was elected in September the US dollar has been on a tear, appreciating nearly 13% against the Japanese yen. Abe has pledged to weaken the yen to fight Japan's persistent deflation and the markets have responded accordingly.

Where this gets interesting is in the relationship between the USDJPY, Japanese holding of US Treasuries and US interest rates. As you know, Japan has been one of the largest sponsors of the US exploding debt load owning $1.134 trillion of the $11.0 trillion US Treasuries outstanding which is the third largest position behind China's $1.16 trillion and the Federal Reserve at $1.66 trillion.

More importantly though is that during the past two years, during the Federal Reserve's QE program, Japan has been the single largest net buyer of Treasuries besides the Fed itself. Since December 2010 of the $2 trillion of US Treasuries issued, Japan has purchased $252 billion after the Fed's $752 billion with China buying virtually none. It's worth pointing out that China stopped adding US Treasuries when the US debt was downgraded in August 2011.

What makes this even more critical is that upon investigation the USDJPY cross is tightly correlated with US Treasury yields and Japan's accumulation of US Treasuries is tightly linked to the trajectory of the currency.

Japan UST holdings v JPYUSD

Chart courtesy of Bloomberg
Click to enlarge

The last time the dollar strengthened versus the yen in a sustainable trend was between 2004 and 2007 when the dollar rallied roughly 15% from around 105 to over 120. In December 2004, Japan was the largest foreign holder of US Treasuries owning $690 billion of the $3.9 trillion outstanding, but by December 2007, as the yen had weakened 15% versus the dollar, Japan had also reduced their holdings by 15% owning only $581 billion. These percentages may be coincidence, but for argument's sake, if Japan reduced their US Treasury holdings by the amount the yen had weakened versus the dollar in recent trading, that would be equal to $147 billion in excess supply hitting the market.

JPY Vs. 5-Year

Chart courtesy of Bloomberg
Click to enlarge

The correlation between the USDJPY and US interest rates can be seen as a proxy for the larger QE short US dollar asset correlation trade. It's quite possible that bond yields and the dollar aren't rising due to an acceleration of growth but rather because the Bank of Japan is blowing up the Fed's QE carry trade. As happened in 2007, when the S&P 500 made a new high as the mother of all credit bubble carry trades was imploding underneath, it may be the case today that investors are again misinterpreting the price action of a blow-off in the mother of all short squeezes in stocks while the QE carry trade blows up underneath.

So here we are at a critical juncture. Both bond yields and stocks appear to breaking out, but it is not clear what is driving the price action. Is this a product of US growth accelerating or a QE short USD carry trade that is unwinding? It's still not clear, and neither side has an edge. It will be very difficult to position for the move, likely breeding an environment of increased volatility. The market is not going to make this easy on anyone, but if you are patient, stick to your discipline, and, as I said last week, leave your bias at the door, the market should begin to provide more answers as we progress through the ensuing months.

Twitter: @exantefactor
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