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A Global Macro Paradigm Shift


The one-way relationship between US consuming and China accumulating reserves has come to a grinding halt. This could be the next phase of the financial crisis unfolding as a new paradigm develops between the two countries.

MINYANVILLE ORIGINAL Last week in The Unintended Consequence of Open-Ended QE I highlighted the rising risk of market volatility due to the nature of open-ended QE and the constant recalibration of the market discount. I also cited the important 150-00 pivot on the US 30YR bond contract, and the fact that a move away from that level in either direction should not be faded.

In preparing for the week ahead I was looking for answers to two simple questions:
There is no more important economic statistic than the monthly employment report, and perhaps the second most important release is the ISM manufacturing report. This week we will get both numbers which are the first since the Fed launched QE III. There are two important questions investors are facing that the market will be answering with each economic release.

What is the current bond market discount for how much QE is forthcoming?

How will the incoming data adjust this discount?

The twin ISM manufacturing and services numbers didn't elicit much market response and the 150-00 pivot continued to see recognition and resistance with the high of the week just shy of 150-08 late Tuesday into Wednesday. Thursday we didn't receive any particularly robust economic data but bonds were failing at resistance, and with the employment data on deck, the bond contract faded to close near the lows of the week below 149-00.

Payrolls came in pretty much in line at 114,000 but a rather large drop in the household survey produced a 7.8% unemployment rate, a post crisis low. This improvement saw the bond contract drop a full point, and despite stocks giving up their entire gain to close unchanged, the bond contract closed at the lows of the day and the week near 147-16, 2.5 points below the 150-00 pivot.

A Bloomberg First Word alert titled Unemployment Drop Moves Up Expected End of QE3 citing Nomura strategist George Goncalves summed up the market's dilemma that I raised last week:

Duration of QE3 should decline by 0.9 month for every 0.1 ppt downside surprise in unemployment rate, implying that today's 0.4 ppt surprise for Sept. (7.8% vs 8.2% Bloomberg consensus est.) "implies a 3-4 months reduction in QE3 related buying."

"This large of a deviation should not be faded as our historical study shows that a selloff triggered by a strong jobs data event lingers for a few more days/weeks."

Supply also a factor as 3/10/30 Treasury auctions begin Tuesday after a bond-market holiday Monday, Goncalves said.

Nomura economists led by Lewis Alexander in Oct. 4 report said FOMC probably does not have a "well defined rule that will determine when to terminate the program."

This is exactly what I was talking about, and the market responded in kind. With uncertainty around the ultimate size of the program, a thin pre-holiday trading session, and supply forthcoming, no doubt bids and liquidity were scarce, however prepared and opportunistic investors were able to take advantage of this volatility. The bond market is oversold and it would not surprise me to see the supply taken down after a healthy concession, but you can now see how choppy trading could become into the end of the year.
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