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Bond Market Strength Forged in the Fires of Adversity

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Contrary to the consensus belief, we may actually be in the early innings of the capacity liquidation adjustment process.

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Last week investors were provided a wake-up call regarding the effects of currency volatility risk lurking beneath the surface of equity and bond markets. Since the beginning of the year I have warned that the insane volatility would eventually find its way into US markets, and Monday (Feb. 25) we got our first taste test of what this looks like. On January 22, my article Are We Witnessing a Tectonic Shift in Which Central Bank Policy Dominates Asset Prices and Risk Premiums? pointing to the parabolic moves in EURJPY and THBJPY, I concluded:

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.

Then on February 11 in Bank of Japan Meeting: The St. Valentine's Day Massacre I analyzed how the yen reflation trade was affecting the bond market, and more specifically, how the 143-00 level in US bond futures that I have been monitoring would come into play:

As you can see on the 10-day tick chart during the following two weeks the US bond futures is clearly "vibrating" 143-00 and has repeatedly tested this level only to turn higher. If the BOJ can't take out 143-00 next week the bond market could be setting up for a big rally as it appears all the yen reflation trade selling has been absorbed.

Then last week in Bernanke's Date With Deflationary Destiny I noted that the long end had taken its hits but that support was holding despite equity prices that looked to make new highs.

You wouldn't know by the price action in stocks, but if you look under the hood, all is not well. This is not a surprise though; equity investors are usually last to get the memo. Usually the first to get the memo are bond investors, and despite insanity in currency and equity markets that has driven attempts to take out 2.00% in the 10-year and my critical 143-00 level in the US bond futures contract, the bond market remains bid. Don't get me wrong. I will respect a failure of these two levels, but if the market makes this area support as fundamentals continue to deteriorate we could see a significant rally as Bernanke's date with deflationary destiny becomes a reality.

US Bond Futures Tick Chart


Click to enlarge

On Monday the market gave us the move I had been anticipating as bond prices rocketed higher with yen currency pairs seeing a massive short squeeze. The EURJPY dropped 5% in a matter of hours and USDJPY lost 3.45%. Stocks briefly melted from the lunchtime highs to lows of the day with the Russell 2000 (INDEXRUSSELL:RUT) losing 2.4% with the S&P 500 (INDEXSP:.INX) seeing similar damage. Though the subsequent swings were large and intense, the equity indices mostly recovered ending the week basically unchanged.

The media focused on the events surrounding the chaotic Italian election and corresponding impact on the euro, but in my mind the catalyst was irrelevant. The takeaway from Monday is that when markets are subject to currency volatility they can turn on a dime and the move can be swift. It would be naïve to think this was an aberration, so investors need to be cognizant of the impact of further yen-based volatility. I will be sticking with the playbook looking to the bond market for guidance.

You may be getting tired of my constant attention to the 143-00 level in US bond futures (March) but hopefully now you are starting to see why it's important. This exercise is the essence of ex ante analysis. On December 28, 2012 in A 2013 Bond Market Prognostication: Why a Breakout Appears Likely, the target was identified due to historical significance and because I believed this level would be the crossroads where the bond market bull/bear battle would be waged. By the end of January the target was met and the idea was that it would see intense consolidation providing a make or break level for the bond market. Then on February 19 in Bond Market Convexity: Objects in Mirror Are Closer Than They Appear I began to tighten up the analysis:

Clearly the market has recognized the 143-00 pivot as the consolidation is in its third consecutive week and there's no doubt that a bull/bear battle is underway as participants jockey for positioning. The key factor for me in determining who wins this battle is whether economic growth and the demand for credit is increasing, or whether recent optimism is simply a function of rising stock prices on the back of a depreciating yen.

When analyzing price action, I believe that you should derive more significance for how markets handle information that is adverse to the trend rather than favorable. For instance, it's easy for markets to perform when the data is bullish but what's more important is how markets perform when the data is bearish.

This rally in equity markets has had plenty of favorable conditions to ride to new highs, including better-than-expected earnings, strengthening economic data, highly accommodative reflationary central bank policy, and not to mention fast money chasing performance. On the flip side the bond market has been given every opportunity to push yields higher, not only contending with the equity bullish data, but also increased pressure coming from the tapering debate, Fed exit talk, as well as more specific market dynamics such as MBS convexity selling that I have been addressing in recent weeks. With bonds holding their gains in the face of a full recovery in equity markets, the bond market strength is even more impressive.
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