as we approached the end of Q1 on 3/28 we wrote in the Internal Conflict Inside the Fed’s Bubble of Fear that:
Meanwhile, stocks continue to rally making it hard to short but even harder to buy. For bonds its the opposite, they are hard to buy but even harder to short. There is a definite internal conflict that is in the process of being reconciled. It feels like there is a lot of tension built up and it may be time for some fireworks. We envision a stock market correction that everyone has been waiting on for 2 months to ignite thoughts of QE 3 and a bond market rally, perhaps to new highs. But the big trade is after that move, not from here. From here the inverted risk-on/off boys look for another ride.
Since then the $SPX is 4% off the top reached on April 2 while the bond market has rallied back to near cycle yield lows poised to test them and potentially take them out. Are we getting the move we anticipated? We think so and believe investors should now be looking for bond prices to make their final leg of the bull market towards new highs. If we are correct we suspect there will be massive divergence between bond yields and stock prices. Since the 3/09 low in stocks that saw bond yield divergence each lower low in yields has been met with higher lows in equities.
We think this is notable divergence and confirms that treasuries aren’t discounting fundamentals but rather reflecting the investment flows of Fed front running. This is an important distinction because where fundamentals could keep yields low as long as growth remains tepid, flows are subject to change when the wind shifts. As in most bubbles, the rally tends to last much longer than many expect and in the end price typically makes investors believe it is here to stay and that a new paradigm is upon us. We won’t rule that out 100% but think it’s very dangerous to subscribe to this reasoning for being long negative coupons in a very crowded trade that is predicated on the Fed controlling price.
Even if they wanted to print all the dollars they need to buy every last bond on the planet eventually they would be faced with a massive devaluation of the world’s reserve currency that would be unsustainable in the minds of foreign lenders. Either bond prices go down the toilet or the dollar, take your pick…
For now we wait and we watch. Our first line in the sand at 1375/1370 $SPX was flushed this morning although the market remains very oversold short term. The next spot is the crucial 1340 level which we expect to be tested prior to next week’s option expiration. From there we will know if this is a shallow correction that corresponds with the Dec pullback or if it is something different. Meanwhile treasuries appear to be headed to the old lows in yields and poised to take them out. We are on the look out for a reverse H&S as seen on the chart at 1.80% 10YR yield and would look to short a break from that area with a tight stop as 1.50% could be a psychological target and we don’t want to be in front of a freight train. Fed meets 4/25 – game on..