Saturday, 2 May 2009

A split personality market may need treatment from Doctor Bernanke

For any investor and especially a macro trader who is looking to trade equity indices, foreign exchange and commodities, a key market global variable to monitor is the yield, and more importantly the direction of travel, of the ten year US Treasury Note.

At the moment it's even more useful to be watching this because you will be in very good company as PIMCO, Blackrock and the other funds that were looking to make some easy money from Quantitative Easing are paying very close attention to the long end of the yield curve.

It is also the case that the Federal Reserve has to be very focused on long yields as they are showing a rather pronounced tendency to keep moving up on an almost daily basis. It is probably becoming quite disconcerting for Chairman Bernanke and the other governors as they contemplate how much longer they can keep selling the idea that they really do have some "control" over rates at the long end.
If, de facto , it becomes apparent that they don't have such control, it will become harder to maintain warm and cordial relations with the likes of Mr. Gross.

While all of this "smart money" is watching its vast holding of Treasuries rather anxiously a lot of other people's money - pension fund managers, mutual fund managers, insurance companies - appear to have spent the last several weeks, initially tip-toeing and now, jumping into SPY, QQQQ, along with a variety of ETF's and most notably of consumer discretionary (XLY) and technology (XLK) stocks. At least one has to assume that some institutional managers are - surely it can't only be Goldman Sachs (GS) and enthusiastic retail investors that are driving this rally.

So a real nasty split-personality market is developing where sentiment is improving because equities are going up (pleasantly circular too - until it isn't), but under the surface the ploy about how the Administration is going to prudently navigate the public finances through their current "difficulties" is looking more and more suspect. The rosy scenario of low inflation, gradual recovery and a supportive interest rate environment - which allows plenty of scope for all kinds of re-financings - looks to be on increasingly shaky ground as the right hand stroke of the "V" shape on the S&P 500's chart becomes ever more parabolic.

It may not yet be a pivotal moment yet for Dr. Bernanke with yields on the ten year note around 3.2% and the yield on the 30 year just above 4% but some key thresholds are going to be breached quite soon.

What does the Chairman have up his sleeve to try to stop the day to day back up in yields? What would make investors rush back into bonds and let Mr. Gross and his chums sleep better at night? In short, what can the Fed do to keep PIMCO etc. on-side to help out with the other rescue efforts which will be required?

Even if the Fed can't actually manipulate long end rates they can help to calibrate the tone of the equity market's perception of risk. The Federal Reserve is more than just the nation's central bank - it is Mission Control for the financial spin industry. A well timed comment from Dr. Bernanke here or a well placed announcement about some new initiative there, and before all of the other people's money can get back safely to the sidelines, risk aversion moves up the agenda rapidly with an ensuing rush into the "safety" of Treasuries and the S&P 500 has a 7 as its first digit again.

Surely the Administration wouldn't want to see stocks go down in a hurry again!

Well - er....no, but actually er...they could dust off the "irrational exuberance" mantra and talk about the need for a more "measured" market reaction to what are after all only the first signs of improving fundamentals. Not a difficult speech to write for a seasoned Fed professional.

The big problem facing the Fed is that, more than ever, it has too many constituencies, with different agendas, to please right now (including, amongst a very long list, the Chinese government) and their room for maneuver is getting more compromised as the debt grows and the need to keep an orderly market in Treasuries becomes critical

I made some related comments yesterday in relation to an article where the author concluded, that in the current market environment, the Fed faces a dilemma. As repeated below, my main contention in regard to the author's analysis is that it actually seriously under-estimates the challenges facing the Fed.
Actually it's worse than a dilemma in my opinion, and it would be better to see that, given the nature of the Fed's position, its efforts to craft a coherent and internally consistent policy and to communicate its intentions to the market, will place investors/traders in what is sometimes called a "double bind"

Wikipedia defines this term which has arisen in different areas of communication theory and psychology as follows:
A double bind is... a situation in which successfully responding to one message means failing with the other and vice versa , so that the person will be automatically wrong regardless of response.
People (Markets) confronted with communications that are of this nature are very often prone to behave in an abnormal and potentially pathological manner.

A manic-depressive market is probably the appropriate response to such a deeply conflicted policy.
We had better get used to this split personality dynamic because I suspect it's going to be with us for quite some time.

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