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Futures Trade Desk- The Emperor Has No Clothes

Trade Desk Client Note

Global Futures Market Review


The Emperor Has No Clothes

Credit Default Swap (CDS) price action on Sovereign nation and Institutional debt has a Sep 2008 look and feel, with liquidity now costing a fortune to access. September 2008 was the start of the financial market implosion, and three years on it looks as though further pain is about to be delivered.

For those uncomfortable with shorting equity indices, it may be time to get to cash, because all markets and most asset classes are on the verge of a major move. Reduce exposure, and had a plan ahead of time that determines entry, stop, and target areas. Bank early and often, and be prepared for some violent whip-saw moves through until the end of the month.


The dollar index is at 79.00 resistance. 1120 on the S&P 500 is a key support area. 1750 on Gold will be a major swing point. Trade Signals will follow as each asset class absorbs the initial moves made overnight.

Operation Twist
The new game the FOMC is playing (Operation Twist), where they have laid out a new ‘Eat Your Peas’ quantitative bail-out plan, involves the Federal Reserve buying long-term Treasuries and selling near-term. The move to implement Operation Twist involves forcing long-term interest rates lower (from already historic levels) and flattening the yield curve. The game however has been rejected by the global market place, as seen in the explosion in CDS rates and near-term implosion in equity indices valuations.

Near-term interest rates would increase in response to the new FOMC bail-out as $300-$400 billion is spent on further manipulation that has no history whatsoever of succeeding as a stand-alone policy. This looks very much like a game of chicken, with the Fed dancing in front of an oncoming depression if they fail to deliver on what they perceive as quantitative measures that will stimulate the economy.
 
Batten down the hatches, because this is going to be a bumpy ride for most investors. Traders who ride the wave of global momentum, and make use of 24-hour Futures contracts will be licking their lips in anticipation of what is to come.

How bonds and Treasury notes are historically used will now change, and a new world order will look at the sustainability of the current situation of continued bail-outs with no real exit strategy outside of hope that change will one day happen. The Federal Reserve (Fed) historically controls overnight lending rates by increasing or decreasing the flow of US Treasury Notes; in the game of Operation Twist that process is taken to a whole new level.

This is the implementation of just another Fed quantitative easing (QE) program, and whatever spin is put on it and however the process is dressed up, it is becoming clear to the masses that the Emperor has no clothes. QE has been an unmitigated failure in spurring economic growth and faith in financial institutions and administration. However, a far bigger issue needs to be addressed in the near-term that could make the 2008-2011 Black Swan events pale into insignificance.

The global investment market likes nothing more than as-is stability, and for the foreseeable future the outlook is far from stable as government debt and financial valuations are addressed via the bond markets.

Treasury Note Process
When rates need to go lower the Fed historically buys back from the market a swath of existing Treasury Notes, therefore decreasing market liquidity and increasing the existing note values. By increasing the value of the note the reaction is for the yield (interest rate) to be automatically decreased. Lower interest rates come from less notes in circulation. When rates need to go up the Fed historically sells more Treasury Notes, therefore reducing existing note values and increasing the yield (interest rate). That move automatically increases overall market interest rates.

In a final gesture, the Fed should look to bank the cash received from the sale of notes into the Reserves, so it can then be used in the next cycle of rate changes.

That may be the historical way that the Fed controls interest rates, but the fly in the Administration (Treasury Dept. and Federal Reserve) ointment is the fact that there has never been this amount of notes hitting the market. The constant flow of new notes is now going to be questioned, as they are carrying the same credit rating as low-volume bond issuing countries such as Belgium.

The 10-year Treasury note has the greatest impact on the U.S. economy due to its influence on long term interest rates. While the Federal Reserve controls the overnight rate, interest rates paid on long term financing for capital goods, as well as the housing market, are established by asserting a premium over the 10-year Treasury note.

Whatever the 10-year note is worth determines the rates for mortgages, investments and loans which are set from the 10-year starting point.

U.S. bond traders may feel that the Fed has been withholding vital information regarding the danger of the U.S. economy not easily coming out of the recessionary phase. Up until the launch of QE3 (Operation Twist) there has been little explanation of how new strategies would try to control massive spreads that are building in the value of insuring against default on the bonds and notes (read credit default swaps).

Something else to address is the cost of banks doing business with each other (read LIBOR, the London Inter Bank Offered Rate), because inter-bank credit pipes are freezing over once again. This is a 2008/9/10/ repeat that has no easy answer.

The Fed did its job in creating global liquidity, the Treasury is doing its job of creating government debt and generating cash, and the market did its job of buying notes that were back-stopped by the Fed and regional central banks.

If there are no cash Reserves getting built from the sale and part buy-back of new notes, and just more QE programs that do not generate much market-wide confidence, what will be used to stimulate the next business cycle move? More importantly, once the required amount of notes flood the market and yields have exploded, how is the Fed going to repatriate interest rates?

Higher near-term interest rates will instigate a stronger Usd. The economic cost will remain an unknown as the Fed may have to once again float an armada of QE boats into unchartered waters.

Another relationship of importance is between the Treasury bond’s price and the interest rate or premium it offers at any time. It is an inverted relationship; when bond prices increase, the yield (interest rate) moves lower, and vice-versa.

This all comes from the fact that at maturity repayment of the principle is paid at par value, and not at bond’s market price; Par value = Current Interest Rate/Price.

Example:
•    A $1000 10-year Treasury note with a 2% yield guarantees $20 a year for 10 years
•     If the note value goes down because of increased amount of notes hitting the markets, from $1000 to $500 for example, the yield increases
•    The original $1000 bond with a 2% interest rate is still guaranteed to pay $20 a year, even though the note value has decreased
•    With an open market value of $500 and still returning $20 the interest rate, or Par, is now 4%
•    The Note value dropped, and in doing so sent the Yield higher

It has historically been seen that the best way to trade bonds is usually during recessionary times, when note values increase due to interest rate cuts, and in times of equity selling. The variable here is the unknown strategy for the Fed to once again stimulate the economy while still containing interest rates.

Another challenge will be containing bond vigilantes that positioned themselves for the downgrade of US debt, and have stayed in those positions until now. All of which is creating fear of loss and volatility that has no release valve.

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