DAn Norcini on the long bond:
Long Bond – Down and Out for the Count or Rope-a-Dope?
With the DOW Industrials breaching the psychologically important 10,000 level to the downside in a convincing fashion this morning, suddenly Sir Alan the Optimist is looking like he has enough egg on his face to make not one, not two, but three omelets. Something is obviously wrong in the la-la land he has been describing. It seems that the market is simply not buying his upbeat assessment of the U.S. economy.
What I find particularly interesting to observe in the midst of this morning’s action is the complete and total disconnect taking place between the commentary coming down the wire feeds, the actual market behavior and the continuing breakdown in normal market interrelationships that we have come to know. Let me explain.
Without an exception, every major news feed story has explained the current rally in the U.S. Dollar as the result of continued spillover from Greenspan’s rather glowing assessment of the U.S. economy and his talk about responding to any potential inflation threat in an appropriate matter. Supposedly players interpreted that to mean that the Fed was signaling that it plans steady increases in the fed funds rate. All of these wire stories mention how the treasury market has now anticipated a series of 4 consecutive 25 basis point hikes over the course of the next four FOMC meetings which would bring it to 2.25%. The consensus one gleans from these stories is that short term rates are most definitely headed higher - This of course is being interpreted by novices to the Forex arena as being bullish for the dollar.
The only problem is that no one seems to have mentioned this to players of the long bond. As I write this piece, the long bond is currently tracking upward with the results that long term yields are GOING DOWN. The result is that the yield curve is flattening out as long term rates are heading down while short term rates are supposedly in the process of heading up. What gives?
I believe the answer is that we are witnessing something that is going to make life interesting for the bond market over the next few months. As stocks begin to swoon in earnest, money is going to come out of stocks and back into bonds reinstituting the "safe haven" play that we have not seen in some time. Investors are getting nervous, Greenspan or no Greenspan, and are unloading stocks in favor of bonds. As they do so, bonds are getting a bid beneath the market which is pushing them up and having the effect of lowering yields on the long end.
That effect is being offset by the fears of those holding U.S. debt who are alarmed at what they see taking place in regards to the massive U.S. trade and current account deficits as well as ballooning federal budget deficit. These same investors are watching the price of oil continuing to defy gravity and refusing to come back to levels where the "experts" have told them it will be trading. Everything that they see tells them that inflationary pressures are building in the U.S. and the value of their dollar-denominated paper is at risk. They are getting the heck out of Dodge and are selling their bonds. And why shouldn’t they? How would you like to be stuck with a yield of a bit over 5% for the next 30 years while inflation is eroding that faster than you can say "oligopoly"?
The tug of war between these two factions is going to add incredible volatility in the bond market until this standoff gets resolved one way or the other. Just when one expects the long bond to finally swoon and long term rates begin their relentless rise, suddenly it reverses to the upside, apparently not down and out for the count but playing a game of rope-a-dope with bond pitsters. Needless to say, this cannot go on forever.
I am of the opinion that eventually, the long bond is going to break down and rates will begin to move up in earnest. Since the dollar rally is nothing more than a dead cat bounce, it is going to fade as soon as the short covering behind it abates. Once that occurs and the dollar resumes it downward trend and breaks support, foreign holders of bonds are going to begin selling them in earnest. The Fed will have to react to keep the dollar descent from spiraling out of control and will be forced to hike rates on the short end. At that time, I believe we will witness both stocks and bonds moving downward in tandem while gold will get its legs underneath it and move sharply upward. The great bull move in gold will then commence in earnest as players flee paper of all national denomination in earnest for the security of the precious metals.
In the meantime, all of this is simply "noise" requiring patience.
Dan Norcini
July 23, 2004
