Treasuries Drop Sharply Ahead of the FOMC

Many are totally stumped by the bond market today.  Bonds sold off hard despite being only days away from Bernanke's apparent QE2 announcement.

I say "apparent" because if you listen to the markets, QE2 is an absolute lock.  When I looked at bonds today I must pull a Lee Corso and scream back "Not So Fast My Friend!".  Actually I believe them(more later)

Let's look at the bond action, and I will elaborate on my thoughts at the bottom:

Here is the 10 year:

Now Let's take a look at the 30 year:

My Take:

I'll start with a question:  If you are a bond holder then why on earth would you be selling bonds less than a week before the Fed is about to announce it's largest treasury spending binge?

Wouldn't you want to hold onto these bonds and sell them off at a higher price after treasuries likely surge on the FOMC announcement?

IMO, there is one of three things that are going on:

1)  If my hunch is correct, there is an old bond game that is being played here that my friend "the credit trader" taught me.

Wall St loves to sell off bonds a few days before an announcements that they believe will be bullish for bonds. 

The reason they sell them off a few days early is it sets up better price entry points.  The FOMC announcement would be a perfect scenario for this "old school" game.

2)  Wall St is not totally confident that the FOMC is ready to move with QE2 so they are dumping bonds as they head for the sidelines.

3)  Inflation fears are taking yields higher as the bond market reacts to the recent sharp declines in the US Dollar and the resulting rise in commodity prices.

My Take:

If I was a betting man I would go with scenario number one. Before I continue, let me emphasize that this is not investment advice. 

However, if you believe option 1 is the likely scenario then buying PUT's on TBT or going long TLT into the FOMC meeting could make for a nice trade.

There is a lot of risk involved here because there are some dangerous inflationary risks that have yet to be priced into bonds. 

Nonetheless, the bond game in scenario 1 has been played for a long time, and the market manipulation seems to be never ending so I wouldn't be the least surprised to see it play out this way.

If bonds do continue to sell off hard into the FOMC then the bond market is clearly sending a message to Ben and his helicopter full of money:  Knock this crap off!

I think the majority of trading action going into next week will be in the credit markets.  I wouldn't be surprised to see stocks move a little sideways heading into the FOMC announcement.

I personally can't wait for next week.  Watching treasuries following the FOMC statement on November 3rd is going to be a sight to behold.  The expectations and pressure on the Fed are enourmous, and they have to walk a very fine line in order successfully avoid any major market disruptions.

I am sure Ben's beard will be sweating no matter what he decides to do.  

Stay tuned.

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