The Start Of Something Bigger In The Bond Market?
From Nic Lenoir Of ICAP
A combination of Fed front-running and perspectives of a more fiscally conservative Federal government (including the ever so independent Federal Reserve Bank) has had the bond market on the backfoot the past few days with a lot of stops being run through. As we discussed last week, how the market digests the actual liquidity injections by the Fed and the buybacks is what will drive all other asset markets. Indeed liquidity injections by central banks has been the sole driver of asset prices with the shadow credit markets contracting.
Don't judge a book by its cover though. The fact that Fixed Income markets have been selling off ever since QE 2.0 started is mainly a matter of positioning going into it more than a market rejection of the Fed's policy. Yes there was quite a bit of (expected) backlash by the international community which suffers from a competitive disadvantage for the most part if the USD is too weak, and yes there has also been some dissenters within the Fed and Washington more broadly. However it was to be expected that the size of the program would be left to possible change based on data (pretty much every Fed decision always comes with that caveat anyways) which can mean both less or more. The fact Mr. Bullard questioned whether the whole $600Bn is needed is part of that conversation, but the weak PPI and Empire Manufacturing surveys released this weak imply that whatever Bullard says won't matter until we see better numbers. In the same line of thought, a little bit of complaining by Europeans about the Fed's policy is not about to make Mr. Bernanke rethink his religious-like beliefs in the marvels of monetary stimulus. Since our academicians had enough self-sufficiency's to criticize the Bank of Japan for the last 15 years, one can expect they are not sleepless over a few comments from the ECB (run by Jean-Claude Trichet who happens to be him too an imbecile, making it easier to shrug off!).
In terms of whether this move is done, I personally don't think it is. There has not been enough panic yet. If the 10Y future re-tested the 122-30 support and the 5Y future the 118-30 level, the market would have essentially retraced the entire pre-Fed move driven by QE expectations. In that sense I feel it is fairly likely that respecting Murphy's law we will go test those levels. By the same token, I do not believe possible for the bond market to sell-off much beyond that in the present state of affairs. If anything talks of balancing the budget and a smaller than expected QE 2.0 program will lead to a more sluggish economy which would certainly reinforce structural deflationary forces and push yields lower eventually as it also alleviates flight away from bonds on solvency/rating concerns. So really until fiscally conservative measures are tested and appear to be failing I don't think we can have a Fixed Income sell-off lasting beyond position squaring. If we follow the Greek tragedy's storyline: a) Market realizes public finance are a complete joke b) a fiscal resolution is attempted c) the fiscal solution fails as the slowing economy choked by austerity lowers revenues and offsets benefits of entitlement cuts. Note that b) and c) should occur in several iterations until entitlement cuts are no longer tolerated and the country is forced to resort to default. We haven't even tried one yet, so pace yourself, and remember that higher yields in Fixed Income creates risk averse sell-offs in other asset classes which in turn create demand for US bonds as money seeks a safe heaven. That status of safe heaven is not just yet abandoned, even though it will be eventually.
So short-term, I expect bounces in Fixed Income to be short-lived until we reach the aforementioned levels. During that time period risky assets should be under pressure. The trend following indicator using the 5-dma open vs. close has resolutely turned, and today for the first time in 3 months the S&P future has broken through the mid-bollinger band, indicating that bounces towards 1,193 should be sold. After that, whether it's risk aversion driving yields lower or the Fed driving yields lower in turn spurring risk appetite remains to be seen.
In the path to default above I omitted the "bail-out" iteration which comes along with an attempted fiscal resolution of the matter as it is only relevant for smaller peripheral economies. When we get to more sizeable bankrupt entities that step will have to be skipped. Ireland finds itself close to that intermediary bonus-bailout stage on its way to default. Part of the issue is that even though Ireland's budget is pre-financed until mid 2011, this has been made possible because Irish banks have bought the sovereign Irish issuances and pledged them in turn to one of the ECB's liquidity facilities. While Germany is perceived as the main player pushing for a bail-out package, it is in fact apparently the ECB which is most pressing on the issue. Indeed the funding scheme used by Ireland via Irish banks pretty much ties the ECB to extend its liquidity facilities until mid 2011. However just for a laugh I would recommend the ECB looks into who has been buying at Spanish auctions. How do you spell cajas again? Could it be that Spanish banks have been buying Spanish bonds and financing them via the ECB liquidity facilities? If messing around can seem like good fun and games when the patient is Ireland which is a small fraction of the European economy, Spain with more real estate inventory than the US (not relative, in absolute number of cases) will probably prove a bit more painful. That's certainly another motivation for Germany and the ECB to push exploring quickly a miniature bail-out and hope the effects are rather soothing on the rest of the PIIGS so they don't have to deal with problems of bigger magnitude. But even such foolish calculation will only buy them a few months. As I have long contended: they are done, the Euro in its present form is unsustainable, and the road to disbanding this wonderful currency will be long and painful as an entire generation of economically moronic politicians struggle to abandon its baby and attempts all sorts of magic to delay the inevitable outcome.
I apologize that I could not add any charts: I am using BBG anywhere and I do not have a set-up allowing to save and send charts, but I promise to make up for it tomorrow!
Good luck trading,