Does one dare defy the bond bubble? Many analysts, including us, often explain the move into US Treasuries as a flight to safety when investors are faced with global economic risk. Indeed, there is a long list of serious risks out there. And the US has the deepest and most efficient capital markets. But we read today another perspective – that the surge in bond prices is actually a result of risk taking (not risk aversion.) More specifically, since the onset of QE and the rollercoaster of expectations for more, bond traders buy up bonds ahead of Federal Reserve bond manipulation (i.e. QE.) And then they sell once more QE is actually announced – a “sell the news” sort of thing. Perhaps this makes sense – it’s a slightly different phase during the risk-taking cycles we’ve seen develop since policymakers took direct responsibility for keeping markets stable. 

 

The Federal Reserve has suggested their unofficial third mandate is to support the wealth effect of a rising stock market. Naturally, QE has very much been positively correlated with share prices. But while buying bonds ahead of QE can be considered a risk-taking trade, it is negatively correlated with QE announcements. But … Morgan Stanley noted back in early June (link above) that a rally in the markets was correlated both with QE announcements and also with improvement in macroeconomic data. Thus, a sell-off in bonds makes sense if macro data was improving (i.e. risks declining.) We don’t expect a QE announcement anytime soon. But even still, this time around we tend to think simultaneous improvements in macro data will be MIA if the Fed does announce QE3. This is when we’ll find out if the bond bubble is a risk-taking trade or a flight to safety. 

 

 

Headlines suggest the market is anxiously awaiting Ben Bernanke’s semiannual testomony this afternoon and then again tomorrow. Not us. It will be business as usual – admission of economic softness, recognition of future growth headwinds, a nod to the employment situation, and the normal reassurances of QE-if-needed. Based on the current state of the US economy and markets, we think it is too early for Ben to unleash QE3. But if Ben has received a few phone calls from his counterparts overseas, then maybe peer pressure will get him to pull some unexpected doves out of his hat. Leading up to this testimony at 10 am Eastern, we think the risk for markets is to the downside. 

 

 Quote 

“The true evil of inflation is that newly created money benefits politically favored financial interests, especially banks, on the front end. Over time, however, the net result of monetary inflation is always the devaluation of savings and purchasing power. This devaluation discourages saving, which is the key to capital accumulation and investment in a healthy economy.” –Ron Paul 

Of Interest 

Merkel Gives No Ground on Bank Oversight (Businessweek) 

Europe’s banks face tougher demands (FT Adviser) 

Morgan Stanley Sees QE3 Rally Lasting Hours Not Week (ZeroHedge, June 6)