To MUCH Interest in Rates?

I had a friend the other day just come out and say to me, "stop complaining, the trend is down." Well, this friend, call him BS (and he is not full of BS), has been doing quite well on the short side over the past few months. Being a contrarian trader that I am, I have missed some big parts of the move lower - taking the much maligned path of jumping in front of the train for which I have been bruised and beaten. These stock markets are plagued by apathy, despair and opportunistic trading. The first two are self explanatory and I could easily make the case that the environment is very similar to the late 2002/early 2003 period where markets went sideways for a while and several tests of the lows were attempted - meanwhile, people gave up with every subsequent dive downward towards 800. As for opportunistic trading (or manipulative trading), lets just be frank; when someone comes into the mini S&P market and drops 7000 contracts constantly hitting the bid around 4pm, nobody is going to step in the way. The opportunity to trash the market is there and to make 10 pts in a few seconds, is a bonus!

This is just one example of the opportunities this market is giving traders. Short momentum players are jumping all over stocks because there is just no support with apathy the ruler at the moment among the bulls. The fear level is high so shorts can pretty much do whatever they want. To be honest, my best trades over the past few weeks have been feint sell signals that turned into amazing three day gains. This is not normal by any stretch of the imagination or at least relative to the trading markets of the go go 90's which had a good deal of volatility. If you combine this free money on the downside with the very high volatility, you create markets of fear and thus support wilts in the face of a sell program. Now, I have benefited on the short side of the NDX and the S&P over the past few months so while its sounds like I am blaming someone, I am instead just chalking this up as pure hard core capitalism - survival of the fittest so to speak. Sure the SEC could look a bit closer at the manipulation around the close or the CFTC could enforce some rules on the trading platforms but in the end, it comes down to the economy and the market conditions. We know how horrible the former is and the latter is not much better.

Which leads me to the point of this story. In markets with tremendous uncertainty and high momentum to the downside (ie equity destruction), treasuries become the soup du jour for the panicked investor. What we have been seeing over the past month is a decent amount of buying in the bond market where volumes are half the norm of the past 6 months - in other words, what you see in stocks with high momentum in thin conditions, you are seeing in the bond market in much the same way - just look at the action in the long bond over the past month. It almost looks manipulated! At the same time, when the average futures volume for the bond has been around 400k earlier this year and then drops to half that in an very high volatility environment, you get exaggerated moves. This current move on the curve has created scenario's now where 2s, 5s, 10s and the bond could all break lower substantially and nobody is in the way to sell it!

So what will draw some volume into the bond market? What will be the catalyst that sends investors out of the bond and into another market? Well, Doug Kass in a piece on Real Money yesterday said that the returns on the BAA rated bond was now higher than on regular stocks, since 1980. That is an amazing fact that argues it was a waste of time to take risk in stocks over the past 28 years! He says what could break up this party is inflation - and I tend to agree. Essentially the conditions are ripe for inflation with inventories shrinking and competition evaporating across industries. A sharp turn in demand opposite falling inventories could create a price spike and break this condition between stocks and the Baa.

In addition to the inflation threat from the supply demand side, there is also the potential monetary inflation predicament. What do I man by potential? Basically, there is a ton of money on banks balance sheets that is not being lent out at the moment. The latest data from the Fed shows excess reserves sky high and if you compare this number to demand deposits, the ratio is almost 1 for 1 vs 6 for 1 over the past 10 years on average. Basically, the banks are hoarding the cash. This is not exactly earth shattering news. So what happens when the first good bond deal hits the market? This could lead to a lending spree by the banks as the money will be available. We saw that in the case of dividend paying stocks with high yields, where it took just one company to trigger dividend cuts across the banking industry - fashionable if you will, to do so. Anyhow, in the early 1990's, during a banking crisis in Sweden, when a deal when through on the lending side, the markets began to thaw. A lending spree could create an inflationary problem as credit hits the economy. Credit expanding, demand rising and falling supply = potential inflation spike.

So the question is this: When will a deal go through that is meaningful to the market? Further, what company will be the leader on this end? That is the ultimate question of sorts and I will have my eyes pealed because if a few deals go through, the money might start coming out of the spigot and guess what, inflation, could come running right down the pike. So in the short term, the bond market is telling us that conditions are very frozen, thin and scary everywhere else. The more they rally in my opinion, the more likely we see a deal come to market because of the lower rates of the long end. The longer treasuries rally, the higher the risk that a reversal and violent one at that, comes.

In the meantime, the bond market remains a market where the buyers remain in control. There is an options expiration coming up later this week which could slow things down but til some resolution in the bond or other asset markets materializes, it is a buyers market. Here are the technical particulars.

• 2s look like they want to break through further to the downside. The 2003 lows sit around .70% and it looks like the same test now wants to be set by traders. This could also have the Fed move on rates again though that would leave them with roughly the same ammo the Bank of Japan had in the late 1990's - in other words, not good.
• 5s are in similar rally mode and it looks like the 2% level is the target...again from 2003.
  
• 10s are on the cusp of moving lower aggressively and testing recent lows around 3.20%. A finish below the 3.50% level would give me greater confidence that things are about to erode further in the asset markets.
• Bond remains thin in trading and long on the traders list. 3.88% looks like the next target.