This past Tuesday two Federal Reserve officials made some hawkish remarks. One comment in particular got a lot of attention. San Francisco’s Fed President John Williams said “Treasuries are priced extraordinarily high.” Most bond traders interpreted this as hawkish. Williams was warning bond rates were too low and therefore the Federal Reserve might be gearing to raise short term rates.
Many investors viewed this comment as something that should send bond prices down, not up. Yet the exact opposite happened. Zerohedge’s post sums up investors’ confusion:
I don’t view this price action as illogical in the least. I have long held the belief that since Yellen took the reins, the Federal Reserve has been too tight and caused the recent global slowdown with their overly aggressive US liquidity withdrawal. Their tightening caused the US dollar to rally too quickly, slipping the rest of the world into a deflationary credit destruction feedback loop. This vicious circle took a pause with the recent Yellen capitulation, but the market is still on edge, worrying the Federal Reserve will return to their frustratingly hawkish policies.
Bond prices are rallying (yields going down) as Fed officials make hawkish comments because the market realizes higher short terms rates will cause an economic slowdown. The bond market wants the Federal Reserve to get out in front with more hikes. Think back to a bond investor’s worst enemy - inflation. The last thing a bond investor wants is the Federal Reserve to allow inflation to run hot. So every time a Fed official indicates they will not allow this to happen, bonds rally. It’s counterintuitive, but a hawkish Fed is the best thing a longer duration bond investor could ask for.
It’s not quite this easy. Depending on the maturity of the business cycle and the shape of the economy, sometimes a rate hike is in fact bearish for the entire curve.
But the important part to realize is that is not the case today. The bond market is sending the Federal Reserve an important message with its reaction to hawkish rhetoric.
Since Yellen has taken over as Fed Chair, she has erred on the side of withdrawing liquidity. First she tapered, then stopped QE entirely, and finally raised rates. And if that wasn’t enough, her team of academic bozos continually signaled higher rates than the market was expecting through their infamous dot plots. The Federal Reserve has been out in front of the curve in terms of raising rates.
I know that statement sounds absurd. The Fed has raised rates only once. How can they be in front of the curve?
All you need to do is look to the US treasury yield curve. Under Yellen’s guidance the 2/10 yield spread has collapsed from 250 basis points all the way down to 104.
This relentless flattening was a big reason for the recent global economic slowdown. The Federal Reserve is choking off US dollar liquidity. The bond market is way smarter than any of us individuals. It knows the Fed has been too tight.
Now you might believe the curve should be flatter. Maybe you think the days of imprudent Central Bank monetary policy should be tossed out and left on the side of the road. I understand that argument. But be aware this sort of conservatism will result in a Japan style lost decade.
There is simply too much debt for the economy to handle prudent Central Bank policies. If the Federal Reserve insists on continuing with their hawkish policies, then the long end of the bond market will prove to be the best investment out there. Long bond traders should be licking their chops at the idea the Fed might raise rates. I am not sure how many hikes would be required, but I doubt it would be more than two before the economy would unravel. The US dollar would rally, commodities would re-enter their negative feedback loop, and the whole January/February collapse would resume.
Instead of getting out ahead of the curve, the Federal Reserve should be hoping for the long end of the bond market to sell off. It means there is a demand for credit and/or increasing inflation expectations. They should shut their mouths and try to re-steepen the yield curve.
Instead they mistakenly keep flattening it. They are not listening to the signals the market is giving them. They are too convinced of their economic models instead of realizing the market is clearly telling them they are too tight…
Time to lean risk back on?
The hawkish Fed comments, along with BoJ’s recent “nothing done” debacle combined with the fact Japan has been on a holiday since last Thursday, has created a difficult environment for risk assets.
I have been patiently waiting for the Japanese holiday to finish. I don’t expect them to sit back as the Yen rallies in their face. But more importantly, their constant QE is an important part of the global risk bid.
I know with the recent poor stock market action, many traders are now getting all beared up, but I am going to take the other side of their trade. As long as Yellen can keep her overly hawkish board members in check, I think the path of least resistance is still up. Now that the S&P is down 50 handles from the highs, I think it is safe to lean long.
I am not a big technician, but one of my smarter twitter friends posted this great chart of the AUDJPY. Dylan D’Costa from Strathbridge Asset Management makes the case AUDJPY offers a good risk reward long trade:
I tend to agree, and the timing works for me. I am leaning more risk on, whether it be trading AUDJPY from the long side, or buying some S&P upside calls, this mini-correction is nearing the finish.
I am putting a lot of faith in the BoJ’s resolve. Let’s hope it’s not misplaced.
Stan the man
Many of you are aware I consider Stanley Druckenmiller to be the greatest traders of all time. At yesterday’s Sohn Conference Stanley made the case for gold. No need to go through again how much I love our precious little yellow friend. And although the number of other hedgies that also have the position makes me a little nervous, I am sticking with it for the long haul.
But what amazes me about Stan is his ability to make concentrated bets in many different asset classes. It’s one thing to nail some macro trades, but Stanley somehow also does it with his stock picks too.
Have a look at Stan’s portfolio:
First thing you notice is the almost 30% weighting in gold. Considering gold is one of the best performing assets in 2016, this was a pretty brilliant call.
But look at the next two positions. More than 40% of his portfolio is in two tech stocks! Facebook and Amazon. Ballsy. But more importantly, unbelievably bang on perfect.
Over the past year AMZN is up 60% and FB 51%. This compares to a 1.5% loss for the QQQ’s and a 24.5% loss for Apple. Druck managed to pick the two best performing large tech stocks and have a monster weighting.
I am speechless as to his investing acumen. There is little I can say to describe how difficult it is to be this right, with such a big position. In my books, everyone else pales in comparison.
Thanks for reading,