Very important to understand.
Caroline Baum is a columnist for Bloomberg News. The opinions expressed are her own.
quote.bloomberg.com
Behold the Bond Market Leveraged Trade Part II: Caroline Baum
March 10 (Bloomberg) -- If you had access to no data other than a graph of U.S. Treasury yields, you'd think the U.S. economy was in big trouble.
Since Friday -- another first Friday of the month, another disappointing jobs report -- yields have plummeted by as much as 35 basis points from already low levels.
Even with lowered expectations after months of dashed hopes, Friday's employment report was a shocker. A scant 21,000 jobs were created in February -- none of them in the private sector. It was the first month since August with no job growth outside of government.
The news set off an explosive rally in a market that had been drifting lower all week. The reaction is understandable, but it probably has little to do with economic fundamentals.
For better or worse, the Federal Reserve ``has tied its policy to payrolls, in an attempt to prevent a preemptive rise in long-term rates,'' says Tim Bond, global strategist at Barclays Capital Group in London. ``The Fed has succeeded too well.''
In that light, Friday's lousy jobs report, which stands out like a sore thumb among a host of other statistics showing strong economic growth, solid consumer spending and soaring corporate profits, was an invitation to leverage up.
Dead Man's Trade
No doubt some investors, predisposed to Armageddon over the horizon, are buying Treasuries on the assumption that the lack of job growth means the economy will roll over in coming months.
However, ``the dominant influence is the carry trade,'' which involves some variation of borrowing short and lending long, Bond says. ``There's an army of people positioned in strange conditional structures'' using options. ``The hedging (by the option sellers) is so large, it's a case of the tail wagging the dog.''
To the extent that interest rates are divorced from economic reality, ``you now can truly say the bond market is a bubble,'' Bond says.
Friday's rally, which spilled over into Monday and Tuesday, was less about money managers changing their fundamental view of the economy than speculators getting an invitation to an open house. Treasury bond futures rallied 2 9/32 points on Friday, the biggest move since January 1991, according to Jim Bianco, president of Bianco Research in Chicago. ``That underscores the knee-jerk reaction.''
The largest one-day move in 13 years ``was not because the real money crowd changed its bearish view,'' Bianco says. ``That's a process, not an event. This smacks of leveraged speculation.''
Two-Way Accelerator
The problem with leverage is that it works in both directions: It propels the market on the way up and on the way down. When the Fed says it's not going to raise the overnight federal funds rate until the economy is generating jobs at a healthy clip, some might call it transparency. Others would call it reckless.
``The Fed has created a monster,'' says Ram Bhagavatula, chief economist at Royal Bank of Scotland Financial Markets.
For starters, even though the Fed has acknowledged the current policy stance is unsustainable, markets ``are still haunted by last year's linkage between payrolls and policy,'' Bhagavatula says. ``The linkage was conditional on the economic backdrop. It made sense when the economy was weak. It doesn't make sense now.''
Second, the potential damage that will result from the eventual unwinding of leveraged trades ``constrains the Fed, encouraging policy makers to act later rather than sooner,'' he says.
Changing Times
Last week, Fed Chairman Alan Greenspan told the New York Economic Club that the current federal funds rate ``is inconsistent with general long-term stability'' without reference to any time frame. Greenspan added that ``this is a very special case that we're dealing with.''
It is special. Never has job growth lagged economic growth to the degree it's lagging now. There are more questions than answers as to why employers are reluctant to hire -- even whether the payroll data, derived from a survey of businesses, is understating job growth.
The promise to keep rates low for a considerable period was struck when the Fed was concerned about deflation, or falling prices, in a slow-growth environment. The central bank's intimation that it would buy long-term bonds to fight deflation and stimulate the economy set off an explosive 80 basis-point rally last May, with 10-year yields falling to 3.07 percent by mid-June.
Changing Rules
Two months later, yields were 150 basis points higher.
The recent rally has the same kind of urgency. It makes perfect sense for leveraged investors to buy Treasuries if someone just announced that, at a minimum, the betting window will be open until late this year. (Interest-rate futures markets have pared expectations of tightening until after the November election.)
At some point, the Fed may get nervous about encouraging speculation preconditioned on the notion of a safety net, a phenomenon known as moral hazard.
``I sense the Fed is trying to change the model for policy setting by suggesting the economy is out of the woods,'' Bhagavatula says. |
