Friday, July 1, 2011

Negative or Positive Yield and US Monetary Policy - Nowhere else to go but the dollar

I have to say, watching the market action this week has been bewildering. I had covered almost all of my equity shorts a few weeks ago when the Russell was in the 790's...I thought that the weakness around the test of that 200 day moving average on the SP500 was high risk and that any bounce would be smaller rather than bigger. While our bounce has not been particularly big, it was big enough to get my new system shorts on the equity indexes once again - which I did not expect. But while watching all of this wacko behaviour, it has become more and more obvious to me that the markets are simply a leverage re balancing tool these days. Like water sloshing around in a bottle, when lots of people are getting blown out of long trades (via margin calls) they tend to think they need to use the precious remaining capital to reverse and then promptly get forced to take another blow out phone call from their broker. Essentially, one of the reasons that the market trades from one idealized extreme to another is because the market is so highly leveraged and people are being taken to max risk on both sides of their trades. Its kind of sad to realise that we really do not have people trading against people, we have debt trading against debt even in the equity and real asset markets. How can we expect reasonable market dynamics when so many people can get over leveraged on every side of a trade?

That brings me to another point. Yesterday, the bond market failed. I had been watching a pattern which generated a "three strikes and your out" move on the upside and was expecting that the very labored rally move in bonds was going to end and possibly reverse. I do want to discuss something that keeps worrying me...just like some of the huge dips (mini crashes even) that we have had in the equity indexes over the last few years...the reality is that people who bought the dips and the crashes did quite well. I can't help but wondering about this gargantuan move in the bond markets. Seems like just enough to get everyone on the take bonds short band wagon...and that bothers me. It bothers me from a technical perspective and it also bothers me because I think that this point, the US and its minions of central planners know that they need to get bonds yielding less than ZERO. This is a great solution for the US especially since the European banks (and many others too) are much higher leveraged and more risky than their already insolvent US brethren. So, people have not place else to go but the dollar. What would it take to make this happen? Well, two things would be ideal:
  1. Find a way to get lots of participants leveraged short US bonds
  2. Crash the stock market
I think that policy makers have a high probability of taking the above approach. Getting people looking short will get make it much easier to kick the can down the road for an extended trip to below ZERO yield on bonds and crashing equity markets will accomplish two things reflect fundamentals and bail the US out of a debt issuance problem. People will be forced to buy US treasuries whether they like them or not.

I am not playing the rates trade as I have said, because it can go either way...I am slightly favoring this scenario...but I see the trade as a momentum trade. If we break out in on direction or another that trend is likely to stick for a while once its confirmed. If we can sustain higher rates then we very well may get both a crashing stock and bond market. If we can get back to bull moves in government bonds then we will most likely get a sustained foray into zero yield which would be extremely convenient for the US Treasury and Banks.  I am just throwing this out I said, I do not have an edge in this trade but I think its good to think of some of the outlandish possibilities that could be irresistible for the mind of a policy maker.
© 2009 m3, ltd. All rights reserved.