I have noticed a lot of confused market pundits who are having trouble understanding the recent market moves. Although I have gotten most of my calls wrong this week, I think I have a fair grasp of what is going on. So let’s go through it.
First up – the move that is confusing the most people – the bond market rally. I think that the bond market rally is quite simple. Common wisdom holds that QE programs are bond positive. After all the Federal Reserve is buying tons of bonds – it must be a net positive. I have another take. I contend that the goal of QE programs is to create inflation. Inflation is the bond holder’s worst nightmare. Therefore QE programs are actually the opposite of bond friendly. If they are successful in their goal, the Fed will have bought bonds that will be declining in value.
Don’t believe me? Let’s go through the charts.
The first QE program was introduced in the midst of the credit crisis panic on November 25, 2008. At first there was a big move lower in yield as market participants were still dealing with the ongoing deflationary collapse. However, as the QE began to work its magic, yields rose.
US 10 Yr Treasury Yield during the first QE program</a> </div>
The first QE program ended on March 31, 2010. Let’s have a look at what happened to yields when the Fed stopped buying treasuries.
US 10 Yr Treasury Yield after the end of QE </a> </div>
Surely that has to be a fluke right? Well, let’s have a look at QE2.
QE2 was signalled by Bernanke during the Jackson Hole Central Bank symposium during the summer of 2010.
Let’s have a look at what happened to yields after that signal:
US 10 Yr Treasury Yield during QE2</a> </div>
Again yields rose during the QE program.
But this time at the end of QE2 when the Fed pulled up off the accelerator, surely yields must have risen? Nope.
US 10 Yr Treasury Yield after QE2</a> </div>
Again, just the opposite of conventional wisdom occurred. Instead of the end of QE causing yields to rise, they dramatically fell!
After QE2 it gets more complicated because the Fed tried to influence the yield curve with Operation Twist.
But let’s just put that aside and instead focus on QE3. What has happened to yields since the Fed has embarked on the program jokingly referred to as QE infinity? This program was open ended so surely it must have caused yields to fall. After all, that is a lot of bonds the Fed was buying…
US 10 Yr Treasury Yield during QE3</a> </div>
Again, just the opposite of what most market participants believed should happen occurred. Contrary to the near universal belief that QE programs are bond friendly, yields rose during QE3!
Fast forward to today. As the QE3 program draws to a close, yields are declining.
Over the past couple of weeks, the bond market has rallied because QE3 is being wound down. It is simple as that. Yes, there are other factors regarding market participants’ positioning that is exacerbating the move, but at its heart, the bond market rally is the result of an economy returning to its natural state of debt destruction.
I had thought that we had hit a point where the economy had reached a self reinforcing virtuous circle. But as the Fed takes the foot off the accelerator with the winding down of QE3, the recent market action is suggesting that the economy is far from self sustaining.
But why are stocks going down?
The end of QE3 is one of the factors causing the recent stock market weakness, but this week’s sell off has been made worse by the fact that the three other major economies have not taken up the monetary expansion baton as firmly as the market would have hoped.
Earlier in the week, like a chump, I fell for the ECB’s dovish talk. Draghi had seduced the market into believing that next meeting he would make everything all right with a monetary ease. The market wanted to believe and I was not strong enough to argue with it.
I had been skeptical of the ECB’s commitment to the recent commitment of easing at the next meeting. However the market took the sweet words of Draghi and ran with it.
But as cooler heads re-evaluated the situation, the reality that the ECB would not be able to ease enough to reflate Europe sank in.
Of course it didn’t hurt that the ECB leaked a story to Reuters trying to talk down expectations:
Five people familiar with the measures being prepared detailed plans involving a potential rate cut, including the ECB’s deposit rate going negative for the first time, along with the targeted measures SME measures. The package offers some stimulus for the euro zone economy but falls short of the large-scale effect the ECB could unleash with a major program of quantitative easing (QE) – money printing to buy assets. Such a QE plan is still some way off.
A June rate cut is “more or less a done deal”, said one of the five sources who spoke to Reuters on condition of anonymity.
A second source echoed that sentiment, and added: “This will be the first major central bank to move to a negative deposit rate. That would move the exchange rate.”
The first two sources spoke to Reuters of a cut of 10–20 basis points, probably in all three ECB rates. The main refinancing rate is currently at 0.25 percent.
Both sources expected the move to bring down the currency exchange rate but said the ECB had made no calculation of how much it was likely to fall by, and had no target for the euro.
This was a huge blow for the markets. Given the Fed’s reluctance to taper the taper, any worldwide global reflation was going to have to be done by the other major Central Banks.
And then after Europe poured cold water on the idea of becoming the global liquidity saviour, the Japanese made the situation all the worse by announcing that their GDP grew by 5.9%. Even though you might think a growing economy is good news, a big print makes it more difficult for Japan to usher in another round of QE. Given that this economic strength is most likely transitory in nature due to a pre-consumption tax hike surge, all that has really happened is that their next QE program has been delayed.
Although I am still hopeful that China might be easing up on their attempt to slow down their economy, to expect them to provide enough growth to save the global economy is not realistic.
Therefore, whereas last week it looked like the ECB and Japan were going to firmly take over the monetary expansion baton from the Fed, this week it became obvious that there no was no true leadership from the world’s other Central Banks.
In the absence of decisive expansion, the natural state of debt destruction crept back into the picture.
I have simplified the story in an attempt to highlight the big picture. It is more complicated than this because, although the world’s Central Banks are reluctant to engage in more QE, there is a concentrated push to affect rates through forward guidance.
I had hoped that the economy was strong enough to not deflate as the Fed eased up on the QE program. I had also hoped that the ECB, BoJ and China would take over some slack.
But there is no political will in any of those countries to lead the charge with the aggressive policies that are needed to arrest deflation.
This is why bonds are rallying so hard and stocks selling off.
Tepper making things worse
Yesterday’s sell off was made all the worse by the words of warning issued by famed hedge fund manager David Tepper the day before. Tepper’s reputation as a market timing god was firmly cemented a couple of years ago when he got on CNBC in the midst of a sell off (ironically caused by the ending of one of the previous QE programs) and said something like the following:
“either the economy gets stronger from here, at which point you want to own stocks, or the economy weakens and the Fed does more QE – at which point you also want to own stocks. Whatever happens you want to be long.” – paraphrasing of Tepper’s comments
Tepper’s reasoning proved prescient. From them on, CNBC referred to the stock market rise as the “Tepper rally.”
Given his guru like reputation, the markets did not like hearing Tepper issue some words of warning at this year’s SALT conference:
TEPPER MORE WORRIED ABOUT DEFLATION THAN INFLATION
TEPPER SAYS U.S. ECONOMY SHOULD BE MOVING FASTER
TEPPER SAYS THIS IS A ‘MIXED ENVIRONMENT’
TEPPER SAYS DON’T TO BE TOO ‘FREAKIN LONG’
TEPPER SAYS ‘TIME TO PRESERVE MONEY’, HAVE CASH
TEPPER SAYS IF ECB DOESN’T CUT IT’S NOT OK
TEPPER SAYS I AM NERVOUS, IT’S NERVOUS TIME
Tepper’s warning, the ECB’s talking down of expectations and Japan’s big GDP print were too much for the market to take.
This week I have traded with about as much panache as a nervous teenage boy at his prom.
The MacroTourist at his prom</a> </div>
The push to new highs shook me off my sizeable stock market short. Although I was wise enough to simply replace my shorts with puts, I really could have used the full delta on the move lower. The rest of my book went decidedly against me.
I have gotten the bond market call wrong and the Japanese Yen is rallying in my face. Not only that, but the other commodity plays like the grains are all sagging as we creep back towards a deflationary sag.
I missed Wednesday’s trading, and that turned out to be an important day. I have been fortunate enough to have a decent start to the year, but this week was not the highlight of the past few months.
When things move harder against me than I anticipated, I have learned to head to the sidelines and clear my head. I don’t mind fighting some markets, but when I am fighting most of them, I am just wrong.
Yesterday I gave up on my bond market short and also my Yen short. Although I think that the trades will both ultimately work in spades, I need to make sure I am not too early.
If I end up re-shorting both of them lower later, then so be it.
I also sold my copper long. It has worked and I need to reduce my metal exposure.
Right now the market has a certain uneasy feel to it. Like the calm before the storm. I am glad that I am long volatility in Yen, bonds and now also stock indexes (though that position is also directional).
This week, I don’t trust myself to do much except to get smaller. So that’s what I am doing. I will get closer to shore and spend the week-end re-thinking my strategy.