Good Morning. If you are looking for what is driving the intraday swings in the stock market these days, you need look no farther than the bond market. Sure, concerns about growth in China also played a part in Monday's roller coaster ride, but from where I sit, the real driver right now is the bond market. While the action is not exactly textbook, it appears that the algos are currently tied to the movements up and down in interest rates. In short, when rates tick up, stocks move down. And vice versa.
In case watching the bond market is not part of your daily routine, the recent move in market rates has been one for the record books. On May 2, the yield on the 10-year treasury closed at a 2013-low of 1.631%. Thirty-six trading days later, the yield hit 2.657%. And if I heard the news report correctly yesterday, this represents the fastest 100 basis point (1%) move ever, which is a long time. So, to say that the bond market is in a free-fall at the present time would be a bit of an understatement.
At issue in the bond market is the realization that the end of the QE party is in sight. While Ben Bernanke has gone out of his way to explain that a reduction/moderation/tapering of the QE program later this year is NOT the same thing as the Fed actually raising rates, the bottom line is the "shake hands with the government" trade (a phrase made famous by PIMCO bond guru Bill Gross, who said during the credit crisis that he always likes to buy what the gov't is buying) now has an expiration date.
So, if you are a fund manager that has a big slug of money invested in bonds, a position that is likely levered up with borrowed money, what do you do with the knowledge that your "trade" is going to end in the not-too distant future? You start unwinding that trade, that's what. So, given that just about everybody in the business is expecting bond yields to soar once the Fed starts to exit (meaning that a 30-year bull market in bonds is going to come to a screeching halt), it appears that everyone who can do so has been high-tailing it to the exits in the bond market over the past 36 trading days.
From a stock market perspective, the general thinking has been that the initial rebound in rates, which just might be one of the most anticipated events in financial history, would not pose a problem due to the fact that rates were artificially low to begin with. Most analysts agreed that it would take a move to 2.40% or above on the 10-year before rates became a problem. Well, don't look now fans but that mark was eclipsed on Thursday of last week and traders have kept selling bonds ever since.
To be sure, the bond market is oversold. When a market - any market - moves that far, that fast (the yield on the 10-year has soared 63% since May 2, 2013), traders know to be on the lookout for a countertrend move, also known as a "dead cat bounce." As such, we weren't exactly surprised to see rates pull back a bit from their highs on Monday. After hitting the high of the day (2.657%) on the first tick of the stock market opening, yields moved steadily lower throughout most of the day and finished at 2.548%. And we would not at all be surprised to see rates pullback to the 2.25% - 2.30% zone for purely technical reasons.
It is important to recognize that if such a bounce in bond prices were to occur, we would likely see a corresponding rebound in the prices of stocks, gold, and emerging markets (well, okay, the commodity and emerging markets space would probably need a drop in the dollar as well to really make things interesting). Therefore, this is probably not the best time to be short the stock market, commodities, or the BRIC countries.
The key here is that the Bernanke gang is none too happy about what is going on in the financial markets. In short, traders have wiped out a fair amount of the "wealth effect" that the Fed has struggled to build over the past few years. Therefore, we should probably expect to hear a fair amount of jawboning out of the Fed in the coming days/weeks. Heck, even Minnesota Fed President Kocherlakota, who is a noted inflation hawk, was quoted Monday as saying that the Fed had NOT become more hawkish with its recent statement.
It occurs to me that since it is not in the Fed's best interest for rates to continue surging, we just might hear more overtly dovish "Fedspeak" in the near-term. In turn, we should probably expect to see that rebound in bond prices, stocks, gold, and emerging markets.
However, after the requisite bounce, the question of the day/year is how much more bond selling is still out there? How many hedge fund managers will be looking to unload positions into the anticipated bounce? How many mutual fund managers will need to raise cash to meet redemptions as even the general public knows that the jig may be up in the bond market. So, while we can probably expect a reprieve from the recent selling in the near-term, this game may be all about the bond market for some time to come.
Turning to this morning... While the algos may have been tied to bond yields on Monday, China is back in focus this morning in the early trade. The People's Bank of China suggested overnight that it would address the nation's cash crunch and would guide interest rates to a "reasonable range." This apparently calmed fears as the Shanghai index rebounded from an early plunge to finish down only a fraction. Across the pond, stocks are rebounding and U.S. stock futures, as expected are following suit. So, with rates holding steady at slightly lower levels compared to yesterday's close, the much anticipated reflex bounce in the U.S. appears likely.
Here are the Pre-Market indicators we review each morning before the opening bell...
Major Foreign Markets:
- Shanghai: -0.16%
- Hong Kong: +0.21%
- Japan: -0.72%
- Germany: +1.42%
- France: +1.35%
- Italy: -0.08%
- Spain: +1.03%
- London: +0.88%
Crude Oil Futures: +$0.45 to $93.62
Gold: +$7.40 to $1284.50
Dollar: lower against the yen, higher versus euro and pound
10-Year Bond Yield: Currently trading at 2.519%
Stock Futures Ahead of Open in U.S. (relative to fair value):
- S&P 500: +10.05
- Dow Jones Industrial Average: +76
- NASDAQ Composite: +21.85
"It vexes me greatly that having to earn my living has forced me to interrupt the work and attend to small matters." -- Leonardo da Vinci
Positions in stocks mentioned: none
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