Is the bond market a bull trap?

Banks have exited Treasuries, while speculative money has piled in despite the risk.

By Minyanville.com Nov 16, 2012 2:52PM
Bull copyright Photographers Choice RF, SuperStockAnthony M. Cherniawski and Janice Dorn

In August, we published at Minyanville an article entitled The Bernanke (Ka)put. In it, we posited that the Fed cannot "print money" without certain unintended consequences. In fact, the phrase “print money” is a misnomer because the Fed actually lends money into existence. All loans must be paid back with interest. 

Since the fall of 2008, money has been pouring out of the stock market in unprecedented amounts, flooding the money markets and reducing interest rates to near zero. This has been a gift to the Fed because it can then lend money to banks at a near-zero rate. They have enshrined this practice into policy, calling it zero interest rate policy (ZIRP). However, this can only last as long as the market allows it.



The bond carry trade
Historically, the federal funds rate has lagged the 90-day T-bill discount rate. The federal funds rate may last only as long as the T-bill rate remains near zero.

Since 2008, the Fed has been able to lend money to the banks at the discount window in order to bail them out of their risky mortgages and loans. From 2009 through April 2011, the banks were able to borrow at near zero percent and invest in Treasury notes yielding up to 4%. This was a bonanza for banks. But the demand for these notes was such that the party couldn’t last. Yields were dropping, cutting the profit margins on this so-called "risk-free" investment.



As yields faltered, the asset values in Treasuries increased, offsetting the loss of income. However, each marginal new unit of investment produced lower yields and smaller increases in asset value. In addition, bond volatility became an important factor for institutional investors. For example, the T-note rally in 2010 produced a maximum yield of 4% with a maximum increase in net asset value (NAV) of 11%. The T-note rally in 2011 produced a maximum yield of 3.74% with a maximum increase in NAV of 11.88%. The T-note rally in 2012, however, produced a maximum yield of 2.39% with a maximum increase in NAV of only 6%. Since its peak on June 1, 2012, the T-note has faltered, reaching  a break-down point on Sept. 13, 2012. The banks (and the Fed) must have seen the writing on the wall by the time QE3 was announced.



The Bull trap is set
As you can see on the chart of the 10-Year US Treasury Note, the bearish wedge formation lower trendline was broken just prior to the Fed's QE3 announcement. This appears to have been a signal for the commercial banks to exit, leaving the speculative crowd attempting to "front run" the Fed after its announcement. 

That is exactly what has happened in the bond futures market. As of two weeks ago, the speculative long exposure in the 10-year Treasury notes had more than doubled from 79,296 net long contracts to 169,456 net long contracts. This is the highest speculator position since March 2008! The futures market is a zero sum situation. That is, for every long, there is a short and vice-versa. The commercial banks are now net short by the same amount as the speculators are long.   

It is noteworthy that the T-Note index has not been able to break above the trendline of its bearish wedge for the past month. On the other hand, a reversal below its 50-day moving average shown on the chart at 132.61 may have severe consequences for speculators owning T-notes. In addition, any downgrade of the federal debt would also have grave consequences for bond and note holders. 

The rise in yield would not offset the loss in net asset value for a very long period of time. We consider this to be a warning shot over the bow for those who have, for so long, sought shelter in the "relative safety" of Treasury bonds and T-notes.


More from Minyanville
0Comments

DATA PROVIDERS

Copyright © 2014 Microsoft. All rights reserved.

Fundamental company data and historical chart data provided by Morningstar Inc. Real-time index quotes and delayed quotes supplied by Morningstar Inc. Quotes delayed by up to 15 minutes, except where indicated otherwise. Fund summary, fund performance and dividend data provided by Morningstar Inc. Analyst recommendations provided by Zacks Investment Research. StockScouter data provided by Verus Analytics. IPO data provided by Hoover's Inc. Index membership data provided by Morningstar Inc.

STOCK SCOUTER

StockScouter rates stocks from 1 to 10, with 10 being the best, using a system of advanced mathematics to determine a stock's expected risk and return. Ratings are displayed on a bell curve, meaning there will be fewer ratings of 1 and 10 and far more of 4 through 7.

123
123 rated 1
262
262 rated 2
480
480 rated 3
651
651 rated 4
649
649 rated 5
629
629 rated 6
616
616 rated 7
496
496 rated 8
346
346 rated 9
111
111 rated 10
12345678910

Top Picks

SYMBOLNAMERATING
EXCEXELON CORPORATION9
TAT&T Inc9
VZVERIZON COMMUNICATIONS8
CTLCENTURYLINK Inc8
AAPLAPPLE Inc10
More

VIDEO ON MSN MONEY

ABOUT

Top Stocks provides analysis about the most noteworthy stocks in the market each day, combining some of the best content from around the MSN Money site and the rest of the Web.

Contributors include professional investors and journalists affiliated with MSN Money.

Follow us on Twitter @topstocksmsn.