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Bond Market Strength Forged in the Fires of Adversity


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


US Bond Futures - Weekly

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The 143-00 level wasn't a guess; it was forged by the fires in 2008 and 2011. Back-testing this area was not a coincidence and the market is telling you this level is real. In last week's rally price stopped where you would expect it to find resistance at the first standard deviation of the regression line but if we are indeed making 143-00 support the rally could take us to at least back to 150-00 and new highs are likely. At this low level of interest rates a move of this nature has dire economic implications.

Investors are trying to rationalize why the bond market remains bid and what it means for the economy. This is a natural progression in the analysis. When the Fed initially launched QE I myself was bearish as I saw the attempts to weaken the dollar in order to reflate assets as very bearish for bond prices as the coupon was under assault to negate its real return. However after 4 years of unprecedented monetary stimulus not only is there no evidence the economy is being stimulated but these reflationary metrics are now seemingly deteriorating as the diminishing QE return is kicking in. At this point you have respect price and holding my critical 143-00 level is key.

One bond trader who obviously gets it and is doing a really good job of rationalizing the situation is Kevin Ferry of Cronus Futures Management. Monday on the contrariancorner blog Kevin argues that the US economic situation has received a misdiagnosis. It's not the assumed liquidity trap that ails us which is being fought with reflation remedies but rather a structural trap that requires a different treatment.

Structurally Trapped economies exhibit similar symptoms but the vast majority of monetary easing is directed at debt support from the prior cycle and political "reform" is timid and tilted toward inefficient industries. The primary beneficiaries of US stimulus were the banks and the auto industry. When the financial system absorbs the principle amount of CB ease, the Structural Trap calcifies in the political arena.

The treatment of a Structural Trap can come in two forms and we advocate a blend. 1) Radical governmental reform at the tax and subsidy level coupled with capacity liquidation. 2) An increasing nominal interest rate term structure.

Reading Kevin you might conclude he is speaking in tongues as his words often transcend consciousness. I am still not sure I completely grasp what he is getting at but nevertheless his concept of a structural trap and the need for capacity liquidation got me thinking about where we sit today in this post crisis process and the consequences for what it will take to come out the other side.

The consensus among just about everyone with an opinion is that we are still suffering from the back-to-back bubbles in technology and then real estate. I think this is extremely shortsighted. The one common denominator behind both bubbles was what I have referred to as the era of easy money that began when Greenspan bailed out Long Term Capital Management in 1998. The era of easy money didn't foster bubbles in tech and real estate, it ignited a bubble in the supply of credit capacity in the banking and so-called shadow banking system.

Since the end of WWII total credit in the banking system (loans + securities) averaged around 45% of nominal GDP (NGDP). However in 1998 credit growth began to expand above this long term average at a rate that far exceeded NGDP growth and by 2008 the ratio of banking credit to NGDP had reached 65%. This relationship is statistically off the charts.
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