Risk in Risk-Free

while the $AAPL love fest is going on after hours and the $SP_F is higher looking to trap shorts tomorrow morning we think investors need to be aware of the potential risk in the $TY_F contract especially in light of tomorrow’s FOMC meeting.

Earlier this week we noted that with the large short position by the large speculators/hedge funds (-174m) in addition to the heavily weighted June call (59m) v put(32m) open interest the market seemed to be very unbalanced going into the meeting as we sit right below all time highs in the contract just north of 132-00.  We noted with the Fed on Deck Something’s Got to Give.

Chart: Bloomberg

With the Fed on tap to provide an updated forecasts for growth, inflation and a policy timeline in addition to the subsequent press conference with Bernanke there is ample opportunity for something to go wrong.  Below in a 60 minute time frame we show the diagonal developing and you can see we have a narrowing apex from which the market will look to break out of at some point.  We can’t be sure which way it breaks but when it goes it should be a large move.  If it breaks to the upside you could see a spectacular short squeeze and as evidenced by Barron’s poll this weekend that showed 81% bearish we certainly think the risk is to the upside.  But make no mistake about it, if the lower parallel breaks this thing could crater.

Chart: Bloomberg

As we have stated yesterday the big debate by Fed watchers is if the low interest rate regime is a function of the reduced stock or increased flow.  The bias on the Fed is that it is due to decreased stock so we believe there is little concern by Bernanke or Yellen or Dudley that rates will go up as long as they keep the balance sheet size the same.  However we think this bias is misplaced and if it weren’t for a massive flight to quality due to last year’s stock market crash that was ironically a byproduct of the end of QE, we don’t think yields would have fallen as far as they did.  Between QE 2 and Operation Twist, the Fed has gobbled up close to 100% of net new issuance.  It would be naive to think that at a removal of the single largest source of demand in the bond market would not have an impact regardless of the size of the balance sheet.  Without the Fed propping up the market and with virtually the entire curve sporting negative coupons we see little incentive for bond investors to step in and take up the slack.  We shall soon see and tomorrow the market might be starting to discount that lack of demand come June…

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About exantefactor

capital market veteran of over 15 years covering multiple asset classes. Focused on analyzying markets ex ante (before the event).
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