Would you rather lose in company or win alone?

August 17, 2010


Long term interest rates plunged today with the 10 year Treasury closing at a new low for the year at 2.56% and the inflation component at 1.65%. My initial target of 2.50% is only a few basis points away but with 98% of traders positioned tonight for lower rates we are overdue for a sharp pullback in bond prices before resuming the downtrend in rates.

History – it’s always important to review

Sunday evening, April 25th I wrote a short but very important update mostly about interest rates and the Fed. Barron’s published a poll of the top 100 money managers on the day before my update and it showed only one manager (someone not afraid to win alone rather than lose in company) was betting on lower Treasury rates while 99 were sure rates were moving higher in the next three months. The 10 year was 3.81% and everyone was sure we were headed higher accompanied by increasing inflation. I wrote that night: “The problem with playing the same side as the consensus is the profit is usually small when you win but losses are large when the majority is wrong as everyone tries to exit at the same time causing panic market conditions. I have been monitoring interest rates on a daily basis for over 40 years and don’t ever remember such a one sided position by portfolio managers that are convinced rates are headed higher.”

I also wrote that night about a sharp decline in the Fed’s monetary base and the correlation to the stock market. “If the correlation continues we should begin a stock market decline early this week” and the stock market did reach its peak for the next day (4-26).

Finally I concluded that night with “the move down in the 2nd half of the year will be to very low levels not seen since 2008 (under 3%). The next 90 days will be crucial for the Treasury and mortgage markets and will determine the next major trend for long term interest rates and my bet is much lower….”

It’s important to understand what makes markets move and what makes them move sharply is the majority betting the same way (because they need to lose in company) and then being forced to exit because of large losses at the same time as everyone else. Unless you are a professional investor it is very hard not to listen to the majority when making decisions because their words give you the confidence to follow in the same direction and yet that is exactly what causes the most pain when wrong. The recent move down in the 10 year from 3.12% to 2.56% in a month was caused by long term portfolio managers using cash to buy long term Treasuries once they felt confident inflation was not going to increase. The inflation component broke below the “key” 2.00% level on June 23 when the 10 year was 3.12% and I urged readers to watch this level for a signal rates would move much lower. The other reason for the dramatic decline in rates comes from the opposite end of the investment spectrum – fast money. The hedge funds that are driven by performance (most of their compensation comes from % of profits) were either betting on higher rates or out of the market. To create profits for the year they must find the hottest market and pounce quickly before the easy money is gone and that is what they have been doing the last few days. The Fed begins its Treasury purchases tomorrow with notes maturing in 4-6 years but the amount is not significant to move the market. With only 2% betting on higher rates it is tempting to go with the brave (or crazy) traders trying to catch a falling knife but it’s always important to remember sentiment almost always leads price. The 2.50% level should be used to lock loans that must be funded in the next few days.

The Chinese are NOT buying Treasuries

The Treasury reported today foreign investors bought $33.3 billion in Treasury notes and bonds in June BUT China sold $21.2 billion as they appear to be diversifying into other currencies and bond markets . Japan did purchase $17.1 billion in June their highest amount since September 2009. Interestingly foreign investors bought a record amount of mortgage securities ($20.4 billion) as they begin to reach for yield because Treasury yields are now so low. These investors remain distrusting of corporate bonds and sold $13.5 billion after sales of $9.0 billion in May. In the past the Treasury market has needed heavy foreign participation to move rates lower but this summer’s decline is clearly coming from domestic money.

Banks loosen credit but does it really matter?

This morning the Fed released its Bank Senior Loan Office survey for July with the good news large domestic banks appear to have eased credit conditions. Domestic banks have stopped reducing the size of existing credit lines for commercial and industrial firms for the first time since January 2009. Banks did report has narrowing of profit margins on loans due to the recent decline in rates and may now be seeking more than just AAA borrowers. BUT it takes two to make a loan and borrowers remain in hibernation because 1) credit worthy corporations are sitting on a record amount of cash and 2) why would they want to borrow when they aren’t expanding operations and creating jobs due to the uncertainty over economic policy, tax rates and increased regulation.

Gold/stock market

Gold rallied today as “insurance” buyers lined up for the best performing asset of the decade. I have advocated a long position all year and with a strong seasonal trend only a few weeks away (September) any sharp declines will be used by traders to add to existing positions. Although the US stock market receives 99% of the press in terms of the best long term investment tonight’s chart clearly shows gold outperforming stocks in the last decade.

For the first time in a week the NASDAQ outperformed the S&P on Monday holding an important trend that is often a good leading indicator for the overall stock market. With the exception of a few days in February of this year the NASDAQ has led the S&P since February 2009 and is one of the key reasons many remain long the market.

Before entering any investment, everyone should consult with their own investment professional and discuss the risk of possible loss of capital.