Self Fulfilling Prophecy: The Bond Trade

asiablues's picture

By Dian L. Chu, Economic Forecasts & Opinions

The 10 year T-Note is currently yielding 2.5%, and the fed`s latest quantitative easing initiative is becoming counterproductive to their stated purpose of trying to stimulate the economy by encouraging more risk taking, i.e., private capital utilization seeking attractive return on investment opportunities. The issue is that Mr. Ben Bernanke and the fed governors although great academicians have failed to take account for how traders and financial markets impact and take advantage of fed policy.

The predominant trading and investing technique on Wall Street, the one that they feel most comfortable employing, is the Trend Trade. There are several reasons for this occurrence, lack or originality, group think, attendance at the same investment conferences, closed community, technical analysis, perceived economic fundamentals, and profitable returns. In summation, continue to trade what is working, let your winners run mentality that pervades Wall Street thinking.

The fed policy is meant to keep interest rates low to stimulate parts of the economy like the housing market and the banking system that can benefit from lower rates. However, the problem is that rates in the bond market are low enough before the latest quantitative easing, and lowering them further is not going to make a meaningful difference in the housing market or banking sector.

Once rates get to a certain point, they have essentially reached the level where any increased economic activity due to the low rates, has already exhausted itself. Therefore, other market conditions, like true demand for housing, and increased demand for loans from banks, , will have to stimulate these sectors.

Equities and commodities are the true barometer for how well the quantitative easing (QE) initiative by the fed is working, instead of the bond market. Since the latest QE, bonds have increased in price, and decreased in yield. In contrast, both equities and commodities--the true barometers for risk appetite--have decreased in price.

By artificially providing incentive for investors to buy bonds, which is having only a marginal benefit to banks and housing, in essence, an ever decreasing rate of return, they are dis-incentivizing risk taking overall in the economy, and feeding into a deflationary loop cycle or investing trend by private capital allocators.

There are measures the fed can employ to stimulate the economy and encourage risk taking, but their latest move has backfired. A good sign that a stimulus initiative is working as intended will be an inflation in the price of commodity as well as equities, and both have fallen dramatically since the latest fed quantitative easing was announced. Forget the bond market as a good indicator of effective stimulus measures, it currently is a counter indicator, and in the midst of an enduring Trend Trade, which is really only slightly different from other crowded trades of the past like the Crude Oil 200 March, Tech Bubble, or Flipping Miami Condos.

Recently, Stanley Druckenmiller announced that he is shutting down his hedge fund, and remarked that "I felt I missed a lot of opportunities in 2008 and 2009 and a huge move in bonds this year," in other words he missed one of the most important money making trades on Wall Street: The Bond Trend Trade where fund managers, encouraged through fed policy really let their winners run to the tune of a 2.5% yield on the 10 year T-Note.

The fed needs to-dis incentivize fund managers and Wall Street to stop the momentum in this Trend; however, they have to do this in a subtle manner. There is a huge component in this Trend Trade who are not seeking the return of their capital, or the 2.5% yield on their capital, but the continual rising bond price is what keeps them in this trade, and out of alternative “risk oriented trades”. Ultimately, this is bad for the economic recovery.

A healthy level for the 10 year would be around 3% to 3.5%; even 4% is not too problematic. But here is the trick, the fed needs to basically keep the bond yield of the 10 year T-Note stagnant at some level for an extended amount of time, or trading in a tight range, they need to discourage any trend in either direction for the near-term.

The last thing the Fed needs to do is to cause a stampede out of bonds, and start the trend trade working in the other direction. So they can even keep their current policy of buying treasuries to keep rates relatively contained on the low side, but augment this policy tool through another technique that adds liquidity in the system in which investors are encouraged/forced to take on increased risk through alternative asset classes like equities, commodities, and flipping Condos in Miami.

The point being that too little risk taking is just as bad for the economy as too much risk taking. And currently, the pendulum has swung in the direction of too little risk taking on behalf of bond investors, encouraged through fed policy, which based upon fund manager returns in the asset class, continues to reinforce the trade, thereby causing most risk assets to depreciate in value, self-perpetuating the very act that the fed is trying to combat, and thus a negative deflationary loop becomes a self-fulfilling prophecy.

There is an even added component to the self-fulfilling deflationary cycle in that as these same investors talk their own book, i.e., the economy is going into a double-dip recession, this just scares more investors, who seek safety in bonds, further reducing risk allocation in regards to capital, thus raising bond prices further, and exacerbating the downward trend of the deflationary cycle.

This is one of the limitations of the makeup of the fed board as it is always made up of PhD academicians who understand the broad strokes of the financial markets, but lack the understanding of some of the nuances of financial markets like the Trend Trade.
The takeaway in regards to Bond prices is that for the near-term they want to keep T-Notes yields at relatively low levels, provide stability for financing purposes, create a boring trading range, and encourage a portion of bond investors to move out of the asset class and take on more risk, thereby moving the 10 year T-Note yield to trade between 3% to 3.75%, with the goal of slowly moving rates back up to normal. 
Dian L. Chu, Aug. 24, 2010

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sbenard's picture

Good and insightful article. I think he's right here.

However, I want to correct something. Commodity prices are not universally falling as was implied. I trade commodities for a living, and it is true that some are falling. However, many, perhaps most, are rising. Most commodity indexes are heavily weighted toward energy, and especially crude oil (some are weighted 80% toward crude), so they appear to be falling despite that many components of the indexes are rising.

Falling: natural gas, cocoa, orange juice, crude oil

Rising: corn, soybeans, wheat, oats, rice, coffee, sugar, cotton, cattle, hogs (some are near their highs of the year)

Do we really want to stimulate commodity prices MORE, when so many are rising and near their highs?

mephisto's picture

I've said this before on ZH but it bears repeating. Bubbles are always parabolic, always super-exponential.

Ie the growth rate increases in time as you approach the critical point. If you see a linear chart, like the one above a lot of other bond price charts are, thats unlikely to be a bubble with a sharp pop at the end. (Bund, Gilt charts are similar).

Personally I'm trading the trend, buying and,yes, selling bond futures. It has worked well for months. Because of the linear charts, I'm not worried by the chance of a bond collapse. There is no bubble, just strong demand.

A Proud Canadian's picture

Wouldn't another difference be that bubbles have no restrictions on ceiling...just need a fresh supply of Greater Fools to keep growing?  Bonds have a "top" dictated by the price which pays zero interest.  We had negative rates in very short term bonds recently but, for people to crowd into buying zero coupon 10 years or even tipping them over to negative would certainly be a distinct psychological marker if not ceiling.

Azannoth's picture

They should(maybe they will) pass a law requiring every1 to take out an 100k loan, they did it with health insurance why not with loans ;-P

Azannoth's picture

Oh wait, by running 1.5 'Trillion deficits they are already doing this! And they get to spend the money too?!


Wow I did not fully appreciate the insidious genious of the politicians

boeing747's picture

Looks like Ben is repeating the same mistake of 1st Great Depression: removing liquidity from market. Most of money included those he printed end up in T-bills, stockes and houses, oh some of money are under cement pavement near 'Put America to work' sign. Real economy is drying up.

Tic tock's picture

My take on the situation is that equities and commodities are hiving off from threat of hyperinflation, but there is a lot of speculative capital that is undecided, which is in Bonds. In that respect, the Fed and various other central banks, have displayed a willingness to preserve some stability. we have to see if prices can adjust to clear the market..that means, what are those low-latency AIs' going to do next? 

Assetman's picture

The author does a pretty good job in linking the trend trade, but really misses two important points:

(1) the Fed WANTS a trend trade to develop in Treasuries.  If Turbo Timmy is pleading for low coupon and long duration so he can raise his $ trillions for the tar pit, you find creative way to do so.  Of course, the blatant front running that came in conjunction with the QE-Lite announcement wasn't necessarily "creative".

(2) it's just as important to remember that the Fed facilitated the trend trade in the equity markets as well.  The author conveniently forgets the myserious runs toward the close or the weekend ES futures lovefest that happened for well over a year.

So what are we left with?  In the equity markets, the silly incentives to spark a trend trade worked pretty well in conjunction with fiscal stimulus.  But the manipulation ended up strengthing the hand of HFT's-- at the expense of fundamental investors.  Somehow, the PhD's conveniently forgot that fundamentals mattered.  Well, now that they've stalled for many companies, they do.  Why in the HELL would fundamental investors get back in after losing in a stacked casino?

As for the bond market, the deeper that the Fed gets into QE and balance sheet expansion-- the tougher it will be to dig themselves out of the situation.  Perhaps the one thing they think they have left at their disposal is the opportunity to dump their (and their banking buddies) purchased Treasuries on the world when the global equity markets go into a tailspin.

For now, the Fed is creating plenty of demand, and the unstable economies in Japan, the UK, and the PIIGS are providing ample sources for continued safety trades.  A massive QE2 action could come before an equity adjustment in an attempt to rise all risk assets... but why do so if cash flows are collapsing?  The QE would need to be targeted at increasing corporate cash flows, unless they want HFT to be 100% of the market.

merehuman's picture

funny thing if electricity should fail or  a breakdown would cause the printing machine to fail..woophsy. What economy

AUD's picture

As long as central banks both purchase outright & repo 'governments' in preference to anything else the trend will continue... until it doesn't.

At some point gold will move into backwardation, then it's really over.

Fishhawk's picture

The Fed is having to print over half the government's budget this year and from now on until the collapse.  Rising interest rates would signal that inflation is coming, and would increase the cost of servicing the debt to an untenable level, thus requiring even more printing, etc, which quickly blows up into a Zimbabwe type hyperinflation.  Thus any unintended side effects (collateral damage) is irrelevant; if the interest rates start to rise, the wheels come off and the whole Ponzi collapses.  This is the corner that the Fed has painted itself into.  Chu is being entirely too kind in assuming that the Fed even contemplates the consequences of its actions, since it doesn't actually have any choices left.

Mercury's picture

The counterproductive-ness of the trend trade isn't nearly as bad as what will happen when managers want out of the trend trade.  And The Fed probably won't be able to finesse how orderly or quickly that trade unwinds.

fxrxexexdxoxmx's picture

How come everyone wants to blame the FED? They are there to help and protect us. They only desire to create a fair and safe environment for the citizens to pursue all the freedoms our capitalist economy provides. The FED loves you. The FED needs YOU. Without the FED there is no real YOU.

Nevermind's picture

The law of unintended consequences: The Emperor Bernanke keeps interest income at zero and therefore MANY consumers have yet another reason NOT to consume, because they want to preserve principal. 

Mitchman's picture

I don't think it is as easy as it looks.  People will not return to risk assets like equities until they are assured that equities are not the rigged game that they are.  With HFT accounting for at least 70% of trading, the explanation of the huge retail outflows out of equity funds is not rocket science.  The whole theory of the FED "forcing" people into risk assets has been a miserable failure thus far and, as bond prices show, has been a total disaster.

Any attempt by the FED to stop the secular trends in the economy and in society are dommed to the same outcome as King Canute's efforts to stem the tide.

Robslob's picture

Oh yeah...another thing that would make people want to take on risk is actually having a JOB so they might have extra money to spend that of course wasn't governement money stolen from those who are already working would help...then there is the economy...

masterinchancery's picture

Reality is even simpler: the Fed needs to go away and not come back.

Market Analyst's picture

I wish somebody would send this piece to the fed, and have them read this article.

Nolsgrad's picture

interesting, what if we get stuck here at super low yields though?