Seeking Alpha
Profile| Send Message|
( followers)

The financial markets were rocked by an unreal break-down at the long end of the yield curve Wednesday. The breakdown was even more surprising since it occurred after a fairly successful auction by the US Treasury. Though the economic future is uncertain, the yield curve is now at one of the steepest levels ever.

The equity markets started with a bullish bias, with all the indices trading above Tuesday’s highs. However, the sell-off in the long-bonds led to a nasty sell-off in the equity markets also. Though the sell-off was small given the environment we are in, the breadth and ferocity showed that the equity markets are no longer ignoring what is happening in the bond market. Incidentally, the U.S. Dollar strengthened against the Euro showing that an element of risk aversion is returning, as is the negative correlation between the U.S. Dollar and U.S. equities.

Mortgage market drives treasury collapse

The U.S. bond markets are not trading within their natural equilibrium due to the massive intervention by the Fed. The Fed has been buying mortgage-backed securities to keep mortgage rates low. This has reduced the spread between the Treasury bonds and mortgages to near historic lows. However, with a steady rise in 10year Treasury yields, the rates on mortgages can no longer escape the Treasury market.

On Wednesday, holders of mortgage bonds started selling them, realizing that their yields could not go any lower. Further, higher mortgage rates will reduce refinancing and pre-payments of mortgages. This increases the duration (a measure of how soon a bond pays back the cash owed) of mortgage portfolios, and forces portfolio mortgage managers to hedge their duration risk by selling long bonds.

The Fed juggling too many balls

The Fed kept the mortgage rates low by buying MBS, which resulted in the tightening of the spread between mortgages and Treasury bonds. They also had an eye on the stress-test results and wanted to keep the equity markets buoyant to allow the banks to raise capital. As a result, the Fed’s statement after their April meeting did not emphasize its plans to buy Treasury bonds. This gave the bond vigilantes the green signal to attack the long end of the Treasury yield curve. Their task was easy given the pending supply overhang of Treasury sales to finance President Obama’s income redistribution agenda. This created an imbalance between mortgage rates and Treasury yields, which caused the dam to burst Wednesday.

Not only are mortgage rates rising, but Treasury bond rates are also spiking. The Fed is clearly unable to juggle so many balls at the same time. What it seemed to forget is that too much cheer-leading will lead to an increase in risk appetite which is not going to be good for the bond market.

Bond yields and green shoots

As I have been alluding too, the rise in bond yields is going to be a significant drain on any economic recovery. Whether it is the first time home buyer, a home-owner wanting to refinance, a corporation trying to raise debt or the US Treasury financing its deficit, rising bond yields are bad for the economy at this point of time.

In an unbelievable irony, the steepness of the yield curve is near historic highs, just two months after the Fed’s internal documents revealed that the ideal short term interest rates should be -5%; i.e. negative. This is likely to put a significant downward pressure on the Fed’s efforts to reflate asset prices, a cornerstone of the plan to the nation’s balance sheet.

The powers that manage our financial markets, cannot allow Treasury yields to stay at this level and expect the economy to recover. I personally expect strong Fed actions to scare the bond vigilantes. The equity markets will be carefully watching the bond markets and if the carnage continues, the equity markets are going to be affected negatively.

My portfolio

With 30 year bond yields reaching a healthy 4.6%, I purchased some iShares Lehman 20+ Year Bond (NYSEARCA:TLT) Wednesday, and added to my ProShares UltraShort Lehman 20+ Year Treasury (NYSEARCA:TBT) put spread positions. As I review the trade after hours, I may have pulled the trigger a bit early since the bond market dislocation is likely going to take some time to settle down. Hence this is going to be a position with a tight stop, while I look to re-enter the trade.

I also opened a bearish put spread on the U.S. Oil Fund (NYSEARCA:USO) which tracks crude oil. Crude oil is trading well ahead of its fundamentals with a massive supply overhang. High bond yields are going to cast a shadow on economic recovery and crude oil is ripe for a pull-back as speculative sentiment changes. OPEC is unlikely to make any changes to its quotas which will not reduce the supply overhang.

Market outlook: Return to quality

The bulls have been ignoring the bad news in anticipation of the end of the recession in the second half of this year. Their optimism is not misplaced since very well respected economists, including the ECRI [Environmental Systems Research Institute] have come out in support of the claim. However the pace of recovery is likely to be anemic. Equities are priced based on earnings, and it is still not clear how a slow economic recovery will translate to earnings in an environment with high yields.

The bond market melt-down may mark a turning point in investor sentiment. Investors are likely to focus more on the fundamentals, instead of chasing the hottest sector. I expect a rotation out of speculative junk equities which have been bid up spectacularly since March, into more quality names. Companies with greater predictability in their financial performance are likely to be in vogue again, perhaps marking the end of the speculative excess of the last three months.

Source: The Bond Market Strikes Back at the Fed