Long Bond's Demise Calms Shaky Stocks

The government signals it will do anything in its power to revive the economy.
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The economy is suffering worse than most people expected. Yet stocks have kept rising, because traders know you can't fight the feds.

Thursday we found out that manufacturers suffered even more in October than forecast and that consumers had sealed their wallets tight. Friday the unemployment rate swung to 5.4% from 4.9% the month before -- the biggest jump since 1986. Yet stocks mostly held their ground Friday after rallying Thursday.

Some will say stocks haven't tanked because the market had already discounted the bad news. Even though earnings will fall and recovery will be delayed, stocks have continued to rally on the knowledge that recovery will eventually come, these people say. Just as we know that warm weather will return in the spring, and that eventually a dying sun will boil seas and leave a trail of orbiting ember.

But the real reason for the rally begins with the Treasury's announcement Wednesday that it will suspend issuance of the 30-year bond.

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For the bond market, the decision was a stunner. There was a class of traders, at hedge funds and Wall Street firms' proprietary trading desks, that had been minting money on bets that the yield curve -- the spread between short-duration and long-duration bonds -- would continue to steepen. It was essentially a bearish trade on the economy, a belief that even as the Fed cut rates, the long end of the curve would stay higher. Those high yields would keep mortgage rates higher than in other easing cycles, as well as make it difficult for companies to raise money in the bond market. As a result the economy would be harder to turn around, forcing the Fed to cut yet again.

The suspension of the 30-year blew that trade out of the water. As traders raced to cover short positions, the long bond's yield slipped to the current 4.9% from the Tuesday close of 5.2%. The 10-year yield fell from 4.3% from 4.4%. Besides annihilating the steepening trades, the deal probably hurt desks that were bringing new corporate bonds to market, market participants say. These desks typically short Treasuries as a hedge against the debt they are holding. Meanwhile, the cancellation has left long Treasury futures and options traders in Chicago worried for their jobs.

Nobody is buying the Treasury Department's line that the move was just about financing needs. Instead, the message they came away with is that the government wanted long yields lower, the market wasn't cooperating, so the government made sure that rates would go down. It did this without regard to the obvious disarray it would bring to the market and without regard to the higher financing costs that will likely come from a slowing economy and waging the war against terrorism. Or for those poor souls at the Chicago Board of Trade with the very active political action committee.

Vincent T. Lombardi

And then there's the larger message from Washington: We are going to do whatever it takes to turn this economy around. We'll spend money, we'll cut taxes, we'll monkey with bond issuance, we'll cut interest rates, and if none of that works, we'll do it some more. Worries about what all this will mean a year or two from now -- that deficits will grow, or that inflation will be a threat -- do not interest us. We're going to bring the economy back and if you want to bet against us we will hang you out to dry.

"You've heard of don't fight the Fed," says Jim Bianco, head of Bianco Research. "This is don't fight the Fed on steroids."

D.A. Davidson trader Jim Volk says this is exactly what he's hearing from institutional clients. While they concede that they may be getting early, with the Fed set to cut rates again next Tuesday, with mortgage refinancing activity exploding higher on the long bond's demise and with the government preparing to send more stimulus down the pike, these investors are stepping in now. "Portfolio managers are afraid of missing the move," says Volk.

If one were a bear one could invent all kinds of ways that this could go badly. Valuations are still high, the government is overmanaging the economy and it will come to no good, etc. But for now on Wall Street, the thought seems to be that one shouldn't be a bear, and in any case the big worry these days is that you might not be on board for the rally, not that you might lose your shirt.