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There
was a time back in the 1980s when bond traders were
“masters of the universe.”
The size
and stature of the
US
government-bond market had exploded, along with the
federal budget deficit. The Federal Reserve’s
inflation-fighting resolve and monetary-targeting regime
under Chairman Paul Volcker produced huge swings in
interest rates. Volatility acted as a magnet, attracting
traders to a market that had formerly been relegated to
widows and orphans.
At the
same time, the stock market had been going nowhere from
the late 1960s to the early 1980s. The go-go years were
still ahead.
By 1997
the capitalization of the US stock market exceeded the
size of the
US
economy. Guess which one was driving the bus?
Government-bond traders were all but forgotten as
derivatives geeks dominated fixed-income desks. The cozy
club of primary dealers that deal directly with the Fed
had less relevance as hedge funds did pretty much what
the dealers could do, only better.
Don’t
write bond traders off just yet. Diminished, maybe, but
not forgotten. What comes as a surprise to the stock
market is often old news to the bond market.
Take the
events of earlier this week, for example. The Dow Jones
Industrial Average soared 331 points Wednesday, the
biggest percentage gains in four years. Every
stock-market story ascribed the broad-based rally to
“hints” the Fed would lower its target rate again on
December 11.
Hints
The
hints came from Fed Vice Chairman Don Kohn, whose long
tenure at the Fed gives him institutional credibility.
Kohn told an audience at the Council on Foreign
Relations in
New York
that policymaking needs to be “flexible and pragmatic.”
He suggested the Fed may have to act to offset the
credit restraint resulting from distress in financial
markets and problems at financial institutions.
A day
earlier, two of Kohn’s colleagues sounded as if they had
just landed from nonplanet Pluto to deliver the gospel
on inflation risks.
During
all this to-and-fro from Fed officials, the stock market
either had its eyes wide shut or didn’t believe what it
saw. The implied probability of a rate cut on December
11, based on fed funds futures’ prices, has been in the
range of 90 percent to 100 percent all week. That’s
about as good as the odds get in financial markets short
of the deed being done.
The
entire Treasury market has been challenging the Fed’s
hawkish rhetoric, goading policymakers with the
attitude: My forecast is better than your forecast!
Now or
later
Counterintuitive as it may seem, the more hawkish the
Fed rhetoric, the greater the expectation of rate cuts.
“It’s
like the old Fram Oil commercial,” says Bob Barbera,
chief economist at ITG Inc., a New York brokerage. “The
bond market is saying, ‘Pay me now or pay me later.’”
Barbera’s exhibit No. 1 is the two-year Treasury note.
The note’s yield fell about 100 basis points from June
to August as subprime “containment” theory started to
fray around the edges. Two-year yields stabilized as the
Fed cut the discount rate on August 17 and funds rate on
September 18.
When the
Fed cut the funds rate again on October 31 and said the
risks to the economy were balanced between slower growth
and higher inflation, the two-year yield took a dive,
falling another 100 basis points in the next three
weeks.
Synchronicity
“The
market is saying if you don’t ease now, you’ll have to
ease more later,” Barbera says.
Exhibit
No. 2 is the concurrent movement in various instruments’
prices and spreads.
“Junk
bond spreads, ABX spreads, financial stocks, the dollar,
two-year notes: it’s all the same trade,” he says. “If
the Fed doesn’t come to the rescue, it’s Armageddon. If
the Fed comes to the rescue, Armageddon is less likely.”
For the
stock market, Kohn’s words were a welcome sign that help
is on the way. (Translation: No reason to be quite so
short.) Why stock investors need extra coddling when the
folks in the bond market had already figured it out is
anybody’s guess. Maybe bond traders shouldn’t give away
those “Master of the Universe” T-shirts just yet. |
