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2007: More Volatile and More Interesting


This week's update...


Higher yields and lower stock prices ahead? End of inversion?

In this week's update (shorter than usual as there wasn't a huge change in positions for hedging accounts), I will touch on the noticeable failure of the 10-year future to break out of the multi-year trend line and the fact that hedging accounts continue to lean hard against the 10 year note and the S&P 500.

Please keep in mind that in this case I am 'thinking aloud' and not making a prediction. I have found that making predictions is a dangerous occupation. But the failure in 10's could have serious implications for stocks, bonds and the shape of the yield curve.

First of all, see the chart here (thank you to Tom Peterson of Bullseye Research for pointing this out to me). It is a very simple chart of the continuous futures contract of the 10 year Treasury future. Note the rather defined 'channel' and the noticeable failure at the top of the trend line.

10-Year Continuous Futures Contract

Could it be that if we stay in this channel, we get a nasty 5-7 point decline in prices? Yikes…

Now take a look at the chart of yields in the 10-year note on a continuous basis. Note that the channel is there, but in reverse of course, as prices and yields move in opposite directions. A move to the top of the channel could mean a move into the 5.50% range. Note that my firm sold many long-term positions at the highs in prices and lows in yields at nice profits and will continue to do so if the channels remain intact. If we break out of the range below 4.40%, my firm will need to re-assess our position and I also think that would bring in a hard landing (recession) scenario. See the chart here of yields.

10-Year Treasury Yields

How are hedgers positioned in 10-year notes? Still short. See the chart here.

Hedgers Net Positions in 10-Year Treasury Futures

What about the inversion in yields? My firm tracks the Federal Funds rate (that is the true measure of rates the Fed is setting) vs. 10-year yields (the rate the market uses as a benchmark for inflation expectations. Note that the inversion is at levels that have usually brought in stiff stock market corrections. I realize that former Fed Chairman Greenspan has publicly stated that inversions no longer are meaningful, but he is the same guy (no acrimony, just fact) that publicly recommended adjustable rate mortgages when fixed rate mortgages were at 50-year lows and just before the Fed raised short-term rates 17 times! So, yes I am sorry to say that I am publicly (respectfully of course) disagreeing with him.

10-Year Treasury Yield Minus Fed Funds vs. S&P 500

What about the hedgers' position in the S&P 500? They continue to lean hard against the market. And they have been rather correct in the past. They are still short the Dow, NASDAQ and slightly long the Russell 2000. They haven't been wrong in the past and I will not bet against them now. Keep in mind that my firm's calculations combine the open outcry or 'big' contract and electronic or e-mini contract together in 'big contract' terms. See that chart here.

Hedgers Position in S&P 500 vs. S&P 500

In sum, it now seems possible that there are a few possible outcomes:

  • The inversion could come to an end as 10-year yields move up.
  • The dollar can strengthen as it usually does at the beginning of the year and in particular in the third year of Presidential terms.
  • Stocks could correct as the hedgers' position suggests.
  • Stocks could sell off as yield increases hurt P/E ratios.
  • The Fed would ease as housing hurts the economy.
  • A Fed easing and corresponding rise in 10-year yields would make the curve steep by the middle of 2007.
  • The Fed eases as fiscal and monetary policies are usually friendly in the third year of Presidential terms.
  • Stocks start weak in 2007 and end strong as sentiment corrects and then strengthens after the second Fed ease.
  • Central banks' purchases are now the 'elephant in the room.' They are making their presence known lately. This has made investors emboldened to buy as there is now a theoretical 'Central bank put.'
  • What the market knows isn't worth knowing. Now that we know that Central Banks are buying, does it no longer help the market?
  • Private equity deals have also put a bid underneath the market. Now that we know they are the other elephant in the room, do they become insignificant to the general markets?

I think 2007 will be more volatile and more interesting. I expect that it will be a sector driven market in equities and my firm will likely become more trading oriented in ETFs and will continue our now cautious stance on bonds unless the trend is broken.

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Positions in Treasuries, S&P 500, Small cap stocks

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