Son Of 'Risk Off' - Michael Ashton - March 22, 2012

Although the last few days' worth of trading is consistent with the type of trade we have periodically seen over the last year or two, referred to with the hackneyed description "the risk-off trade," it isn't much risk and it isn't far off.

After a 21% rally in the S&P since November, prices now stand a whopping 1.2% off the highs. Wow, time to get in!

After 10-year note yields rose 45bps in two weeks, they have now fallen 10bps. Be still, my heart!

Spanish 10-year yields, down from 7% in November to 4.8% earlier this month, have reversed the February rally from 5.41% to 4.80% to return to 5.47% - only 153bps below the high yields. Calamity!

Ten-year inflation swaps, which began the year at 2.25% and closed at a high of 2.75% two days ago, drooped all the way to 2.68% today. Tantamount to deflation!

Hey folks, cool it. Nothing much has changed, yet. Initial Claims today was 348k when 350k was expected. Housing Starts on Tuesday recorded 698k rather than 700k. Existing Home Sales showed 4.59mm rather than 4.61mm. There are disappointments, and then there are disappointments. This is the disappointment that sends a stock lower if the company doesn't beat the "whisper number," even if the earnings are still great.

Markets will, though, probably get a boost from the comments of Chicago Fed President Evans, who commented in a speech after the markets closed that "clearly more accommodation would be appropriate." I assume he is speaking about monetary policy and not the size of his hotel room, and if so then it's a remarkable statement to be made about an economy that's growing at or above a 2% rate of growth. Dallas Fed President Fisher, on the hawkish side of the spectrum, says on the contrary that he won't support further quantitative easing, but that's not really a surprise. In any event, there's clearly disagreement at the Fed about further QE. That's almost mind-blowing to me given that we are not in a state of crisis, most policymakers tell us we shouldn't worry about a resumption of financial crisis, and economic growth is doing fine (although it's not booming!) with the exception of some clear signs of inflationary pressures. If they can't get fair unanimity about holding off on QE3 now, then either they know the chances of further disaster are not as remote as they say, or QE3 will be on the table forever.

This was, in any case, roughly the right place for the bond selloff to take a pause. The chart below gives the very-long-term monthly closing chart of the secular bull market in bonds. As with any long-term chart of a series bounded by zero, as nominal yields are, the chart makes the most sense logarithmically. The very regular decline in yields had a false breakout in 2008, a re-test of the lower line (which I took at the time as the turning point of the whole bull market, incorrectly), and then a more-durable breakout over the last year.

The selloff so far has taken us slightly inside the lower trendline, which is an unstable position. Either yields should move somewhat higher from here, exiting the area of the trendline, or this should represent just a re-test of the breakout and lower yields are to persist for a while. My view is that the selloff we are currently experiencing, which is in line with normal seasonal patterns, should result in no less than a return to the channel and a migration back slowly towards 3% 10-year yields. However, we have to keep in mind that the breakout from the natural, secular decline corresponds to the Fed's direct and almost unprecedented manipulation of long-term interest rates (I say "almost" because the Fed back in the 1940s pegged long-term interest rates, but the market was much smaller then).

This chart, as much as any other, shows how unnatural the intervention has been, in disturbing the market's natural rhythms. That also means that the Federal Reserve is rowing against the tide, but so far they have been successful. I can't rule out the possibility that a QE3 might hold rates near 2% (although it is hard to see them much lower than that, in any case, while there are massive deficits and rising inflation), but I take the bearish view.

Although TIPS remain expensive, they are nonetheless still cheap to nominal bonds. Now that breakevens are 35bps wider they aren't as cheap as they were, but I still vastly prefer to own TIPS at a -0.10% real yield than nominal Treasuries at 2.28%: what could well end up being a much worse real yield.