Did the Fed Blink First Last Week?

Click to enlarge

In Friday's trading the tension between the short end and long end of the US Treasury spectrum saw some rather dramatic adjustments. Surges at both the long and short end were seen but it was the two year note which was the biggest surprise as it jumped almost 30 basis points. The chart above is an ETF which tracks the prices of 1-3 Year Treasuries (SHY) and the large gap down in Friday's session indicates the magnitude of the surge in yields.

There were also indications from the Fed Funds futures that traders are now factoring in increasing probability for rate hikes from September onwards.
The moves of last week were addressed in my Daily Form commentary last Tuesday and in particular in the comments on the Five Year yield (second item)

There is one theme which I am confident about which is that, unless we get another major leg down to the rolling financial crisis, the bull market in US Treasuries which carried from the October 1987 crash until December of 2008 is over.

Yields on the five year note saw the largest relative jump yesterday and I would expect that as long as traders in equities and commodities continue to push the reflation agenda the market’s focus will move increasingly towards the shorter term securities, in particular 2 year notes.

Re-reading that comment today (June 7th) it would seem that the reflation traders are winning and that in fact the Fed blinked first, and it was revealed in Bernanke's remarks in Washington last week. Whether things will continue to play out well for the reflation traders and badly for those hoping to refi mortgages is less clear and it may be that the Fed (and equity markets) will decide that even if emerging markets deserve a bid, the US consumer is still tapped out.

Comments

[John Lounsbury:]

If the reflation scenario occurs too quickly the new bubble will pop, violently. I am reminded of an analogy to binge eating - gorge, purge, gorge again, etc. If we do not take the time necessary to digest the food, we are doomed to a dismal existence.

Jun 07 03:41 PM

[bbowen7:]

Note the week of June 1, as the time that we passed from concern for deflation to recognition of the reality of inflation. Hopefilly Bernanke has the cajones to stand up to Geithner and Obama. Does anybody have a professorship open for next year when his term on the Fed expires?

Jun 07 03:47 PM

[Mistrofan:]

Let me explain again for those who seem to miss the point: there is NOT reflation (or inflation) and we will see no inflation in 2009 or 2010. What we see is a run from the USD. And that has NO inflationary pressures. More than that, all the balance sheets(consumers, businesses and banks, except US Gov and FED) are still pointing to continuation of a DEFLATIONARY environment. I am afraid there are still too many epople confusing the run from the dollar with inflation. At the end of the day every bird dies siging its own song....

Just my 2 cents.

Jun 07 05:33 PM

[Jasper M:]

I'm with Mist here. There is to much bad credit out there, that simply cannot be repaid, nor any believable guarantee assigned to it, so it is doomed to evaporate. And as it goes, it removes purchasing power from the system. Since there is a contagion effect here, this can remove purchasing power faster than the Fed can create it (especially since all the Fed's means of Quickly creating 'money' are credit based).
Fed & Treasury together cannot 'reflate', in the long run, until so much credit has been destroyed that the availible Federal Reserve Notes again become a significant percentage of the money supply. And that will take a WHILE. YEARS.

Jun 07 10:00 PM

[Mad Hedge F...:]

Nope. First of all, let me warn you that reading this paragraph is a complete waste of time. Still interested? There is chatter about that the Fed is considering raising interest rates at its next meeting. After all, where can they go from zero, but up? The bond market is certainly telling us that rates should go higher, with yields on ten year Treasuries jumping from 2.45% to 3.95% since March. This is the usual kind of gibberish you get from financial journalists, who deep into a summer with no real news, resort to making stuff up out of thin air. US industrial capacity utilization is terrible and still falling, while unemployment is still rising at a record pace. Sure, commodity prices have doubled this year. But this is happening because investors are looking for an alternative to the sick dollar, not because there is huge underlying demand by end users. This is one of the reasons why I have recently become cautious about all of my long positions. So I can say with complete confidence that the chances of an interest rate hike are less than zero for the foreseeable future. This discussion did have the one benefit that it did enable me to fill this space in my newsletter.

Jun 10 11:12 AM