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Guest Post: The Fed's Distortion Of The Butterfly
Submitted by John Lohman
It’s interesting to note that the 2s-10s-30s butterfly has been a funding source and part of the risk trade since the Fed decided to set the price of all things risky in November of 2008. It hasn’t been as meaningful as the FX carries or some of the other risk trades, but a factor nonetheless.
Over the last ten years, the correlation coefficient between the 2s-10s-30s butterfly and the S&P 500 has been -72.5% (using daily data). Of course, the Fed has eliminated every ounce of market integrity in the 458 trading days since it became the marginal price-setter, so this relationship (like so many others) has been obliterated. The impact of the Fed’s financial douchebaggery are best illustrated by comparing the last 450ish trading days with the 450 trading days prior to mid-November ’08.
Before:
After:
It’s interesting to note the last divergence (early summer 2009) was resolved by the S&P 500 following the butterfly (think Mike Santoli’s “the bond market’s idiot kid brother”). Perhaps unlikely, but a convergence here would equal SPX 870!
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for idiots like me please explain why this is something I shouold know, what it implies, etc.
It simply means what once was up is now down, and what used to be down is now up.
The market really doesn't exist anymore as the FED has for all intents and purposes has taken totalitarian control over fixed income, equities, and risk of any kind. The FED is trading just about everything via it's emmisaries (PD's) and a few black box algos designed by kids who have not yet grown hair on their balls.
This clip says it all - insert Ben B as House and dying patient as our economy
http://www.youtube.com/watch?v=XCbBUjwxnA8
Should I start trading with Cramer?
Go back to Huff Post. Don't trade.
We (day)trade pairs of these, but add the 5yr. So we have 2s/5s, 5s/10s, 10s/30s, etc.
Our butterflys would be 5s/10s/30s, or 2s/5s against 10s/30s.
The past few months the 2/5 pair has been getting smoked and the 10/30 pair has been going through the roof, meaning both the 10fly and the 2/5/10/30 have been going through the roof.
The 2yr yield is near nothing (meaning the 2yr price is very high), but the 5s and 10s are still getting bought up far harder than the 2s and 30s.
+10
5/10 is being bought, but the 10/30 not nearly as much. However, the 10/30 might just break trend...
When I talk about the "2/5 pair" btw, I mean "long 2s against short 5s".
So our 5-10-30 is long 10s against short 5s and 30s. That's what makes it a butterfly, because it's a play between the "wings" and the "body", vs just an outright up/down move.
So our 2vs5 has gotten way cheaper while our 10vs30 has gotten way stronger, meaning 2s and 30s have lagged the 5 and 10 rally.
I was saying the same thing- the 30yr has not moved like the 10 or the 5. I was giving you props for mentioning the 5, as the sell side has been focused on the 10-2.
Oh ok. No props necessary, our firm just happens to trade tightly correlated pairs, so 2s vs 5s, 5s vs 10s, 10s vs 30s.
Every so often we see something about the 2s vs 10s, and I guess people watch it for the basis point difference, but it's not something you can really trade. A 1:1 ratio (short 100 2s against 100 long 10s) isn't a hedge since further out on the yield curve you get a lot more movement. You'd basically be naked long 10s.
We trade them in certain ratios based on typical movement, so we'd have on over twice as many 2s as 10s: short 215 2s against 100 long 10s. (So if the 10s sold off 5 prices the 2s would probably move down two prices and leave us at a scratch.)
But even with those hedges, the curve has *still* moved rather dramatically.
I am an idiot too.As I understand it and as you can see from the graph above, the relationship between bond and stocks is more or less diametrically opposed. When stocks are moving up, things are good and nobody needs the safety of bonds. Coversely when things are not going so well ...like now...everybody is in bonds. At present it seems that stocks are up and bonds are up. The implication is that the banks are taking the money that they are getting for the bonds and using it to prop up the stock market. Some believe/calculate the market should relly be between the 6000 and 8000 mark.
The implication is that if the fair value is in the 6-8k mark, then any stock you are looking at now is 25% overvalued. The market high is not ddriven by actual value created by people working in companies and providing goods and services, eventually this will be realized and there will be hell to pay.
It could be tomorrow it could be in 10 years from now, but a correction is going to happen.
All honest men should have left the market a long time ago. I dont know why any company with integrity would want to be listed on this. You may as well hire a town cryier to scream out a random number every couple of minutes and trade on that.
cool that was my reading. borrow from the fed,(buy bonds) get the spread use the money to prop up the stock market.
Another couple of things...
The Fed has fisted so much liquidity up the financial system that the price of every financial asset is going up.
All the folks worried about a bond "bubble" should know that if bonds burst, then stocks will be crushed much worse.
Exactlly!, both markets will collapse. Total market meltdown with nowhere to run. Of course, I meant to say that the banks got the money from the FED. Although I am still comfused as to how the money ends up in the banks pocket, so that they can rig the equity market. Its time for an infographic or a cool flash animation, for the rest of us
btw, If the bonds crash and the stocks crash, where does that put the USD as a currency? ...oh the humanity!
I believe it would make it strong as balls, because you're talking about immense wealth destruction.
How did you arrive at that conclusion? how does wealth destruction improve the USD? If the markets collapsed..whatever that means for the bond market, would that mean that the selloff would in effect monetize all Ben's paper as everybody moved to cash? and if so, would all that cash be chasing whatever was left of value, ie going for physical things on mainstreet, companies, gold, Monets, uranium whatever, leaking all that money into the main economy and thereby triggering hyperinflation...and the end of the USD?
In fact thinking about it any foreigner buying us bonds is really importing inflation.
I'm not speaking for Ragnar D (and would love to hear his response), but since I agree with his conclusion, here it is:
wealth destruction = deflation = strong currency (via PPP)
Empirical observations from history support this somewhat academic conclusion.
Well you're kind of skipping a step there. You can't just say "markets collapse, people move to cash, now there's a bunch of cash, ergo inflation".
People would be moving to cash *because* everything was losing value. In other words, if Dow goes from 10k to 5k, your 100k retirement account is now worth 50. Also, everyone is dumping everything else they own to pay their bills, so your 200k house can't sell for 100, your 30k car can't sell for 15k, etc.
The only way you can "move to cash" is by basically writing down the value of everything you own in a fire sale. If you live within your means and have savings, well great life just got cheaper.
But for the 90% of people who've long since converted would-be savings to ipads and nights at the club, and who are also in debt up to their eyeballs, there's very little cash for them to "move to"--they're hocking the ipad on Craigslist (at the same time everyone else is, so they only get $80) just to make next month's payment on a car that's worth nothing.
Having the stock *and* bond market sell off massively, which isn't supposed to happen, would mean massive wealth destruction, which means less wealth chasing the same goods.
didn't we just see this happen in the euro zone, currency, bond spreads, and stocks
deflation does not mean wealth destruction. it mkeasn wealth destruction for all the over leveraged banking asses and top 1% who own everything in this country (why do you think the fed hates it
for those who live within their means, have now debt, have avoided the ponzi scheme e call a stock market the value of their savings goes up. meaning for the poor and the majoority of americans deflation may be a net gain.
Well we didn't see that in US bonds, but I agree with most of your post.
Both inflation and deflation can be destructive, but inflation punishes anyone who's ever saved or lived within his means, and rewards the deadbeats. Deflation at least has a silver lining--it makes life cheaper for anyone living responsibly.
But if IS still wealth destruction, because nearly everything loses value. Your house, whether paid off or not, loses value. Maybe you don't intend to sell it, but it is an asset and is now worth less, as are your stocks, your cars, etc.
Even though you've been living within your means, anything you try to sell will be competing against the fire sale of everyone else dumping their stuff onto the market trying to get some cash to pay down their debts and expensive lifestyles.
"Fisted Liquidity" the new banker band, coming to you soon!
(.. as soon as they've ripped everything off, that is..)
I see a new moniker for someone........
The primary points are:
1. the markets are totally divorced from fundamentals
2. you can make intraday money arbing the spread between the butterfly and the e-minis
3. on a longer (than intraday) basis, the S&P has become very rich to the curve
4. the curve is smarter than the S&P
@dcb,
I'm not a trader either, so I have to figure out the language, too.
Bottom line: the equity market and the bond market normally move inversely to one one another (i.e., normally, when bond yields go up, stock prices go down, and vice versa). Post-November 2008, the bond market and the equity market have generally moved together, which indicates that something is broken (or rigged, if you'd prefer).
Convergence bitchez!
Any human watching the markets has known this for some time. A GM fecal employee can even figure out where that corpate cash is? Bonds...
James Bonds?
(resistance was feudal!)
I can't tell if you're a joker, a spy, or a serf!
FED interventionism has distroyed many long held statistical relationships and when the full QE 2 comes on board they will distroy the Treasury market much like they have distroyed the MBS market
They will not stop, they will not fail. Until they fail utterly and completely and take the entire system down with them.
I've been doing some reading on other systemic collapses of various kinds over the centuries, nearly all of them central bank or central power directed. The social disruption and devastation simply has not been seen nor witnessed in 80 years so there's no institutional memory. Which is precisely why it will be allowed to continue to the bitter and ugly end. Everyone will believe they will not go that far until they have gone even further. We are our own worst enemy, thus we are helpless in the face of our utter inability to stop ourselves.
Kondratiev, Bitchez!
Douchebaggery, Bitchez!
I like looking at lots of dots
Me too. It pays well.
great bunch of comments gents. Keep up the knowledge sharing....go ZH.
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