Wednesday, August 10, 2011

How Markets Don’t Work!

It's funny how the markets work.  Everyone expects one thing, and the market does the exact opposite.

Case in point:  The US gets its national credit rating cut, and every US Dollar bond and US Dollar bear in the world figures that this is it... this is the big one... finally, interest rates are going to spike higher!


Since getting the credit rating cut from AAA to AA, we have seen the US Dollar remain fairly steady, and US Government bonds have rallied huge!  In fact, intraday on Tuesday 9th August, 2011 we saw 10 year bond yields go below the 2008 low, all the way down to 2.036% - resulting in higher prices. WOW!

You have to think about this now -- why would bond yields go lower than the 2008 low? What could possibly be looming on the horizon that is so awful that bond yields would pierce the low set during the greatest market meltdown since 1929?

In a word, RECESSION.

The Fed pretty much came out and confirmed this thesis when they said that they would keep rates at ultra low levels until at least mid 2013!!  That’s almost two years away. WOW AGAIN!  Do you know how bad the internal data must be if the Fed is publicly acknowledging that they will not raise rates for 24 months?

So How Low Can Rates Go?

The irony was not lost when, after S&P announced that it was cutting US credit rating, China publicly blasted the US over its "bloated welfare costs".

Imagine that -- a communist country putting America down for being too socialist!

The funny thing is that, since the USA lost its AAA rating, bond prices have soared in value. In fact, over the last three days the Chinese have seen their Treasury holdings appreciate by tens of billions of dollars. (bond prices rise when relevant market interest rates drop)

For all their tough talk about how reckless the Fed was being when it announced QE2, they must have been secretly high-five-ing each other as their 1.16 trillion dollars worth of Treasuries appreciated in value by an estimated $100+ billion!!

Since QE2 was announced, we've seen 10 year yields drop from 4% to 2%, and we've seen much steeper declines in the 2-5 year duration, which is where China has MASSIVE exposure.  So that $100 billion gain guesstimate could be very conservative indeed.

Did QE2 Work?

It sure did!  Just not for you and I.

In fact, I know you have been asking yourself who benefited the most from QE2? After all, equity investors certainly didn't win... the average US worker didn't win.

You want to know who the winners were?

The only winners were Government and other bond holders.  And by the way, want to know who the two largest holders of US government bonds are?

YEP! It’s China and the Federal Reserve!

Want to know what's going on?  Just look around at who’s got the biggest slice of the pie.

It's no surprise that it was the Fed, and the US’s next single most important banker - the Chinese Government.  The US didn't break the 2008 yield lows on a fluke -- the market is telling us something.  It is shouting from the roof tops that we will almost certainly experience a recession in 2012.

While equity prices rebounded, after getting pounded so relentlessly again, I'll be looking to fade the rally and get short some more stock because unless we see a miraculous turn around in the employment and GDP figures we are going lower as far as equities are concerned anyway.

But we may go to 1,250 on the S&P 500 first before we see 1,050.  So, nimble traders: have fun.  Longer term traders: wait for the roll over, at which point you'll be able to short 'em all.

In the meanwhile, I’m getting longer on secured corporate bonds from entrepreneurial corporations in Asia