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Self Fulfilling Prophecy: The U.S. Treasury Bond Trade

Interest-Rates / US Bonds Aug 25, 2010 - 03:48 AM GMT

By: Dian_L_Chu

Interest-Rates

Best Financial Markets Analysis ArticleThe 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 QE 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, M.B.A., C.P.M. and Chartered Economist, is a market analyst and financial writer regularly contributing to Seeking Alpha, Zero Hedge, and other major investment websites. Ms. Chu has been syndicated to Reuters, USA Today, NPR, and BusinessWeek. She blogs at Economic Forecasts & Opinions.

© 2010 Copyright Dian L. Chu - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


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