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The Bond Market is taking Advantage of Janet Yellen`s Dovishness

Interest-Rates / US Bonds Aug 21, 2014 - 10:54 AM GMT

By: EconMatters

Interest-Rates

Push the Limits

It has been a common theme in financial markets to push the limits on any possible edge, so if there are restrictions on banks and financial institutions use of leverage, lobby for change, or if activity falls under a certain governmental regulation, alter the activity so that it is classified under a different interpretation so that previous limits can be exceeded.


Talk Up the Dollar ‘Treasury Speak’

It is so common for Wall Street to front run any legislative, Federal Reserve or Treasury policy agenda that policymakers have in the past always been mindful to at least talk the market out of being so blatantly one-sided that they get way offside on the trade. Think for example about the many Treasury officials who talked up the dollar saying publicly that they want a strong dollar when the markets knew that in reality the Treasury was by practice weakening the currency, and wanted to devalue the currency. But by talking up the currency Treasury officials didn`t signal a white flag, and have everybody and their mother shorting the US Dollar, as when trades are that one-sided complications arise when everybody needs to get out on a short squeeze, plus a collapse of the dollar would be highly problematic, so they needed at least a modicum of restraint by markets.

Helicopter Ben Era versus Janet Yellen Dove among Doves Era

However, with Ben Bernanke he was known as ‘Helicopter Ben’ for his dovishness, that if things got bad in the economy, he would literally throw money out of Helicopters at the economy to keep it from sliding too far into recession territory and a downward spiral. I am paraphrasing with considerable leeway here, but you get the gist.

But even Bernanke would have balanced remarks, almost academic in nature to show that he played Devil`s advocate on the pluses and minuses of fed policy initiatives. However, Janet Yellen has taken dovishnessto an all-time high or low depending upon your perspective, there is no pretense of academic balance in her stance on monetary policy, and markets have not only picked up on this, but they are taking advantage of her dovishness to get way off sides on trades and financial markets.

Run the Fundamental Numbers

Let us just take the bond market, there are other markets that are bubbly, but let us look at the 10-year bond, as the level of irresponsible risk taking in this market is really unprecedented given the circumstances in the economy. Yes one can be irresponsible and take excessive risks in any market including those conservative bonds. We saw some of the froth come out of the high yield junk bond market last month, but treasury market speculation has been untouched, and is as one-sided as I have seen it given the fundamentals in the economy, and is really bizarre to say the least.

Read More >>> The Bond Market Explained for Mohamed El-Erian

For example, the 10-Year Bond has a yield of 2.4%, the inflation rate is somewhere in the 2% range, and going higher as some of the lower print months drop out of the annual 12 month calculation set, so the trend for inflation is a right angle on the charts, 2% and rising. The economy has been growing around 2-2.5%, and each year is slightly stronger than the previous year. The Unemployment rate is near 6%, and the economy is producing more jobs on an annual basis than at any other time since 1997, plus the amount of available job openings are at a robust 4.7 million. The most since 2001 for those who want to employ the ‘labor slack’ argument to downgrade the robust job market of 2014. Sure the economy may not be perfect but when is it ever perfect, remember a couple of years ago when a 40k employment month was the norm?

The Numbers Just Don`t Make Sense

So on a forward basis let us just say the inflation rate is 2.1%, subtract this from the 10-year yield of 2.4%, and an investor in these bonds is getting paid 30 basis points or 0.3% to hold these bonds over a ten year borrowing time frame with budgets set to soar once the entitlements kick in during this ten year borrowing window for the government. Factor in borrowing costs of 15 to 25 basis points, let us say 15 for the sake of argument, and the investor is getting paid 15 basis points for taking this kind of risk over a ten year time frame with rates by everyone`s account set to rise sooner than later, maybe as soon as the first quarter of 2015 a la James Bullard.

Excessive Size Leads to Excessive Losses on the Backend of the Trade

The only way this trade makes any sense is if a financial institution loads up such a massive size that the arbitrage carry makes sense on a ‘short-term’ basis, and they can push bond prices higher and realize price gains on these investments. And therein lies the insane risk to the financial stability of markets that the Federal Reserve through excessive dovishness is incentivizing with these ultra-dovish market expectations that enable excessive borrowing at extra-ordinarily low rates, and buy anything with a positive yield carry trade regardless of the long term risks involved.

Read More >>> The Oil Market QE Premium Is Coming out of Price

Have to Talk Up opposing side of Policy Agenda

This is why government officials from the Treasury on down have always talked up the other side of the trade that they are making to avoid extreme risk taking in financial markets, and what Janet Yellen has failed to master in her short stint as Chairperson. It is going to be her undoing as Chairperson, as basically Janet Yellen`s dovishness has been taken for granted to such a degree, that bond traders effectively think they can get away with murder, that is if excessive risk taking relative to the fundamentals of finance was a criminal offense. Janet Yellen is a dovish doormat for financial markets, and all one had to do is look at the fundamentals of financial markets to come to this conclusion, financial markets are taking advantage of her dovishness to take risks that just don`t make any rational, or fundamental sense from a risk reward perspective!

Bond Stampede

There is no way these bond investors are holding all these bonds for 10 years with a 15 basis point spread return, so Janet Yellen is setting the stage for the biggest stampede in the history of the bond market as the rate hike cycle begins, even the markets have the first rate coming at the halfway point of 2015 with a 50% certainty.

Janet Yellen Needs to better Prepare Markets for Inevitable Rate Rises

The sheer size of the trade that she has encouraged, and the exodus from this non-fundamentally based trade, is going to severely, and negatively destabilize not only the bond market, but inflict major turmoil on many derivative asset classes as this massive stampede out of bonds begins. This moment is going to be unprecedented in the bond market, something that no one is prepared for, or taking any steps to hedge against, because where is the safe haven, gold – in a rising rate environment? Janet Yellen needs to start talking more hawkish just to lessen the severity and market destabilization of the stampede out of bonds to get some investors out before the stampede begins in full force.

Bond Market Crash looks on the Horizon thanks to Federal Reserve Dovishness

At this pace the bond market could crash with a 2.4% yield and the Fed six months possibly from the first of many rate rises, she needs to better prepare financial markets for the inevitability of rate rises, as right now they are so unprepared like the village where the boy who cried wolf, when the wolf comes the village or in this case market participants are completely shocked and unprepared for the carnage that ensues.

The stampede out of bonds is going to be unprecedented in nature because there is no fundamental reason in the economy to have a 25 basis point fed funds rate with a 6% unemployment rate, and a 2.4% yield on a 10-year bond. It is just bizarre once one does the math, it is the epitome of irresponsible risk taking by bond investors, and going to end very badly from the way interest rate expectations are being managed by the Federal Reserve. Get more Hawkish Janet Yellen, and start at Jackson Hole, as traders are already discounting this speech once again, in short they don`t respect you, and are taking advantage of your dovishness!

The Federal Reserve cannot have their cake and eat it too on this one because on one hand they want to keep excessively dovish expectations regarding rate rises, but yet on the other hand expect markets not to have to ‘overreact’ when needing to re-price financial assets because now ‘interest rate expectations’ are behind the curve and need to catch up with the speed in which the Fed is forced to raise rates to have interest rate policy more in line with a 5.5% unemployment rate in 2015.

By EconMatters

http://www.econmatters.com/

The theory of quantum mechanics and Einstein’s theory of relativity (E=mc2) have taught us that matter (yin) and energy (yang) are inter-related and interdependent. This interconnectness of all things is the essense of the concept “yin-yang”, and Einstein’s fundamental equation: matter equals energy. The same theories may be applied to equities and commodity markets.

All things within the markets and macro-economy undergo constant change and transformation, and everything is interconnected. That’s why here at Economic Forecasts & Opinions, we focus on identifying the fundamental theories of cause and effect in the markets to help you achieve a great continuum of portfolio yin-yang equilibrium.

That's why, with a team of analysts, we at EconMatters focus on identifying the fundamental theories of cause and effect in the financial markets that matters to your portfolio.

© 2014 Copyright EconMatters - 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.

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