The bailout of Spain has begun and the market’s reaction suggests that it has found little comfort from the 100 billion Euros that have been allotted to backstop their debt. The initial drop in Spanish yields was short lived as the market closed nearly where it had begun the day. Immediately the talk turned to Italy’s ability to maintain serviceable interest rates on their debt. Followed immediately by Ireland leveraging the situation to their advantage by seeking to renegotiate the terms of their bailout to match Spain’s favorable terms. Otherwise, Ireland may simply default. The net result was the continued evacuation of money from the European Union and into the U.S. Dollar and U.S. Treasuries. The flood pushed Treasuries to record low yields.
We are at a critical juncture in the decades long Treasury rally and I believe that we are nearing the top. The political unrest overseas has the ability to accentuate the last leg of this move and create a major spike high and the CFTC’s Commitment of Traders (COT) reports show unequivocally that major bets are being placed on both of these outcomes. This creates the setup for a steepening yield curve going forward as short-term rates decline on a flight to safety while long-term rates begin to more accurately reflect the inflationary nature of the monetary policies being enacted by both the European Union and us.
The major market players’ actions have begun to crystallize since the beginning of March. This started the Dollar and Treasury rallies in earnest. We’ve seen a 7% rise in the Dollar and a 200% increase in the commercial traders’ position. Meanwhile, Treasury price rallies of 4.5% in the 10-year Note and 10% in the 30-year Bond have pushed the futures markets to record low yields of 2.107% and 2.608%, respectively. These price rallies have had the full support of commercial traders as they loaded up near the March lows, increasing their positions by 65% in the 10-year Notes and 122% in the 30-year Bonds.
There are two important things to notice in the preceding paragraph. First, is the disparity between the price rallies of the 10-year Note and the 30-year Bond. This provides a feel for how much more volatile the interest rate picture gets as it moves out on the timeline. Secondly, it demonstrates how well the commercial traders forecast price swings in the U.S. interest rate futures. Both of these facts are supported by their winning trading accuracy of 73% in the 10-year Note and 64% in the 30-year Bonds via the COT Signals nightly trading signals.
Market sentiment and the actions of the large Treasury traders changed substantially towards the third week of May. This is when it appeared that the equity sell off might have halted. The tell came when equities continued to slide into June and commercial traders shed less than 20% of their long 10-year positions with the expectations of continued low short-term rates while simultaneously selling off more than half of their 30 year Bond position to match their expectations of inflation in the future.
Successful traders don’t make a living by catching the reversal of a 20-year trend, nor do they ignore the fundamental thesis of the politics of the day. The current picture is quite clear that politics must keep short-term rates near zero as the European banking system absorbs the full brunt of a panicked public. Traders are also keenly aware that what is borrowed today must be paid back in the future. Therefore, traders are using the market’s current volatility to calculate future interest rates that reflect where the global economies will be, rather than where we are.
Crestmont Research has a wonderful site full of scholarly research on both the equity and index markets. Part of their research in the interest rate field shows that the vast majority of times, interest rates will fluctuate by at least 50 basis points over every six month period at some point along the yield curve. We’ve already illustrated the volatility of the 30-year Bond. Putting their research to work for us provides a six-month volatility envelope in the December Bond futures with a high price of 154^20 and a corresponding low yield of 2.251% and a low price of 140^06 and a corresponding high yield of 3.251%. Clearly, commercial traders are signaling their expectations that the low price, high yield scenario is the one that plays out.
Link to annotated charts for this blog – here.
This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.