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Parsing the Treasury Action



The exercise of parsing the meaning in the Treasury market's action -- and the 10-year yield in particular -- is a valuable intellectual exercise insofar as it helps us understand some of the macroeconomic forces (structural and cyclical) at work. And when visibility on a microeconomic scale is so limited, it's even more beneficial.

I'm a stock guy so the one thing I'm sure of is that I'm not as familiar with the nuances of the fixed income market as folks who watch these markets all the time. But is it possible that that old rule of thumb, Occam's Razor, is applicable here? This postulate suggests that any unknown phenomenon should first be explained in terms of what is already known: that the simplest of two competing theories is the preferable one.

What do we know?

• That 80% (roughly) of bond bear markets start immediately before or immediately after the Fed increases the Fed funds target rate.

• That the latest CoT (commitment of traders) data suggests that commercials are basically flat and large speculators and small traders aren't at extreme positions.

• That Street economists' overwhelming consensus view is that the 10-year will yield 4.5% in 2004 (they were high by 250 basis points in 2003).

• That most asset managers (see the most recent Merrill Lynch asset managers survey) think the bond market is overvalued.

• That the anecdotal consensus among traders and the media is that the bond market is in a "bubble."

All of the above argue for lower, not higher bond yields. Yes, I know the short-term sentiment measures are extremely optimistic, suggesting some sort of pause is in order. But the above items suggest that any correction is more probably mean-reverting rather than trend-reversing.

As for what it all means, that's the hard part. No one can say for sure if bond buyers are telling us that the economy is likely to disappoint in the second half of 2003 and beyond, or if they are just responding to the massive liquidity the Fed has injected into the system and Greenspan's virtual promise to buy them back from those same players at par (or better) in the open market. When given the opportunity, I always follow the Occam's Razor rule: The simplest explanation. In this case, the latter, not the former, is simpler.

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