Fed Rate Cut Talk Reveals Bond Market as Overvalued

So now the rate cut talk begins…or perhaps it has been going on all along but I did not notice? In any event, Friday's sub 50 level on the ISM had many in my world now buying treasuries like they are going out of fashion.

Confirming the cut talk was the massive moves in the 2007 Eurodollars which are now pricing in the possibility of 3 cuts by September next year! The hedgers and fast money crowd jumped in with both feet. On Thursday, the same crowd jumped into treasuries following the break of 4.50% in the 10 year note. All told, there was a whole bunch of buying occurring in Chicago over the last few days!

Much like the fast money folk, I jumped in on the long side of the March 10 year once the 4.47% level was taken out. With support from the bond chart, which argues for the bond to trade to 4.50%, some people I talk with are looking now for 4.25% in 10 year yields. I am looking for more of the 4.30% area on 10s as the yield has entered another trading range from the fall of last year. The 4.30% level would be the previous low from that time period before we began the move to 5.25% earlier this year. Do I believe it should be down here?

Well, my Fed funds indicator actually argues that at the moment, fed policy is easy – fair value is 5.45% versus the current target of 5.25%. In addition to this fact, the 10 year yield is now a full 1% lower than this fair value indicator. Over the past 7 years, this has occurred only twice (though several times when it was too far above the funds indicator). When it was below previously, it signaled a turn for stocks which exploded higher once the 10 year started to sell off and move higher in yield (a removal of fear that things are getting bad). When it was above the funds target, it signaled that the stock market was extended and due for a pullback (things were perceived too good – something that occurred often during the bear market).

So what will happen with both the stock market and the bond market both extended? This is like a game of poker with each player throwing in more and more chips. With gold holding firm and the CRB turning nicely, I have to argue that the bond market is way overvalued and thus should be higher based on pure fundamentals. The economy has not turned over (though many who argue that housing is going to collapse would have you believe such).

If it were, the stock market would be going down (we are only marginally from the highs) no matter how much stimulus the Fed was providing behind the scenes. Due to the recent fear in the market of what the ISM signals, the stock market is taking a beating, similar to those instances I mentioned before. And given the caution that I argued for previously in terms of the Vix and the S&P, the 10 year yield looks like it has support to move to 4.30%. At that point, we either get something from the fed in terms of a cut or the yields start rising.

I remain long on 10 years for this week.

Comments

[Justin Moy:]

Interesting analysis Dan, but I respectfully disagree with your outlook on the 10 year yields. You argue that treasuries are overvalued, yet you are long the market and looking for 4.30% on the ten year. If you were making that trade purely on momentum, I could understand, but even that momentum trade is not worth the risk/reward, especially given that the 10 and 14-day RSI went below 30 earlier this week. Much of the recent speculation of Fed cuts for Q1'07 was based on the housing market slowdown spreading to the rest of the economy. That has not proven to be the case--as you agree in your writeup. Though the Chicago PMI and ISM-manufacturing numbers were slightly below 50, the service side of the economy, as represented by ISM-services and the employment report (which came out today, after your report was written), demonstrate the reslience of the US economy. Moreover, hedge funds and speculators have been piling on bonds since the beginning of the summer. Take a look at the CFTC Trader COT reports: very few speculative shorts are in the market, and with everyone on one side of the trade (being long) and predicting lower yields, I felt comfortable shorting the 10-year note future this week. After today's job report, even the most bullish of bond traders must admit that the rest of the economy outside manufacturing/housing/... is pretty solid. The biggest red flag of all this week? Bill Gross/Paul McCulley going on CNBC earlier this week and talking up a 2 or 3% handle on the 10-year next year. With all due respect to those guys: yeah right (sarcastically)!

2006 Dec 09 02:40 AM