Tuesday, July 6, 2010

Rise in Treasuries Overwhelms the Market Rally

What a roller coaster today today.  We saw an initial 171 point pump job on the DOW before giving up most of the gains by the end of the day.  The 10 year bond dominated the trade today although you would never know it if you watched "Bubblevision".

 Let's take a look at the 10 year bond(TNX) trade over the past few months:

As you can see it's pretty much fallen off a cliff since May and it was down pretty sharply again today despite the rally. 

So is the bond market pricing in deflation?  That and more in my view(more on this later).

The bottom line here is this chart on the 10 year is flat out frightening for anyone that is involved involved in the credit markets. 

Let's put this move into perspective by looking at the TNX trade back in 2008 versus today:

My Take:

As you can see by the trendline above, we are now seeing lower yields on the 10 year than we did during the crash of 2008. 

This is pretty remarkable when you consider that all of Wall St thought the whole financial system was about to collapse back then.  The fear was 10 fold what it is today and yet the 10 year yield is now lower today then it was back then.

The all time recent lows on TNX of course were as a result of the Fed's infamous QE announcement in 2009.

So are the credit markets more afraid today then they were in 2008?  I believe so because the recent economic data is rapidly looking like it did in 2008(possibly worse).

Folks, there will be no significant stock rally with the 10 year reaching new lows on an almost daily basis.  Bonds must begin selling off in order for stocks to move higher.  This is why the rally failed today.

I mean think about it:  We had every reason to see stocks soar this morning.  We were deeply oversold,  Europe has strongly rallied as we opened, and the futures had bounced back up to +17 on the S&P right before the open after being as low as -10 last night.  This was a very powerful reversal that should have set the table for a strong rally.

The market instead ended up laying a pretty rotten egg.

Within an hour after the markets opened I knew the rally was going to fade because I noticed the 10 year was still moving higher.

Strong rallies typically need solid outflows from bonds in order to be sustained.  Without the bond market participating it forces the rest of the market to lose confidence.

I am sure traders expected the 10 year bond to sell off hard after the impressive 170 point rise seen shortly after the open.  They figured the risk trade was on for the day and the 10 year would act accordingly and move down especially considering how badly oversold the bond was. 

Just look at the chart above folks:  The 10 year had been literally selling off almost everyday for the last couple weeks.  When the 10 year went the other way on the strong opening the traders immediately took notice.

The lack of participation by the bond market told traders that there is a lot of big money that's very afraid right now.  Stocks then started to roll over as a result.

So why the flight into bonds?

I believe the answer is multifaceted: 

1)  The economy stinks and investors are afraid of weaker than expected 2nd half corporate earnings which is sending many to the sidelines via treasuries.

2)  The European sovereign debt crisis.

3)  The risk of deflation appears to be very real.  If this scenario plays out the 10 year will be under 2% in no time.  This will not be good though folks because it means the economy is in shambles.

4)  The bond market is attempting to front run the Fed's QE2.

Let me talk about #4 a bit.  Bernanke's 2002 thesis on fighting deflation involves a "last resort" response where the Fed begins buying the long end of the bond curve in order to peg rates to ridiculously low levels. 

In theory this would lower rates and make it easier for this country to service our debt.  It would also theoretically potentially stimulate lending which would help turn the economy around and stop deflation in it's tracks according to helicopter Ben.

 John Mauldin had an excellent piece on Ben's 2002 thesis last night on Seeking Alpha.

The Bottom Line

Personally I believe that Ben is smoking a crack pipe if he believes this thesis will work.  People do not have any desire to go out and buy $600,000 McMansions anymore.  Most Americans don't even know if they will be working two years from now.

Why on earth would Ben believe that we want to take on more risk via Ponzi financing under such unstable economic conditions. 

Additionally, the unintended consequences of doing another QE blitz are numerous:

The bond market could potentially panic and take rates in the other direction if they begin to agonize over even more deficit spending and the threat of default.

Also, with below rates below say 2% on a QE 2, how does a house ever appreciate in value? 

You know rates down the road would only have one way to go from 1-2% rates that we would see on the long bond rates post QE Part 2(that is if the bond market behaved).. 

The value of these houses that would be bought at 1-2% rates would drop because borrowing would inevitably become more expensive as rates rose once the economy began to recover because we would have to protect ourselves from inflation in a growing economy.

Buying a houses in this type of low rateenvironment would leave you with an asset that is guaranteed to lose value over time. 

I am sure there are other unintended consequences of such actions.  The markets could potentially panic on a QE2 announcement because the perception would be that the Fed thinks the country is about to get smacked by deflation.

All of this being said:  I am not sure such a move by the Fed would ever be allowed by Congress. The Republicans and some of the Democrats would be strongly against more deficit spending.

Ben could possibly pull a Hank Paulson and tell Congress that the world is going to end if he doesn't get his way.  I am not sure this would work this time.

Let's hope this country finds the political will to stop all of the bailout/QE nonsense by the Fed and it's bankers.  Deflation is coming and there is no way for the Fed to stop it.

Disclosure:  No new positions taken at the time of publication.

1 comment:

Jeff said...

Bonds are finally selling off.

This rally could have legs today.

The rally is setting up a nice short entry. I would love to see us get up to the 1100 area.

This would be a sweet short.