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A few days I ago I wrote a blog post suggesting that we need to be careful reading too much into low Treasury yields.  I’d like to take a little time here to expand on my comments from that piece.

There has been a lot of talk about new historic lows in long-term US yields. We’ve clearly seen a break below the lows put in back during the financial crisis when 10yr yields approached 2% but didn’t break below. As the chart following shows, that break finally happened in 2011, and we’ve since see the market move down to near 1.50%.

The thing that doesn’t get mentioned in all the talk about rates being so low is how much of the long-term Treasury issuance the Fed is holding. The Fed went through two rounds of quantitative easing (QE) where it bought Treasury and mortgage securities. It has been running Operation Twist for the last several months whereby it sells short-term Treasuries (think T-Bills and short-term T-Notes) and buys long-term securities. That’s helped bring the yields on 10- and 30-year securities down.

It is important to keep this in mind for two reasons. The first is fairly obvious. Operation Twist is set to conclude at the end of June. That would remove a major buyer from the market, reducing demand for long-dated Treasuries. Much debate these days revolves around whether the Fed will react to recent weaker economic data to either do more Twist or to initiate QE3, or some other type of easing effort. There are folks looking for something to be announced coming out of this month’s FOMC meeting, but the comments from Fed speakers recently haven’t leaned in that direction (though certainly we could see a change of tone).

The second reason I think we need to keep all the Fed buying in mind is the size of the holdings in long-dated Treasuries the central bank has built up. It’s substantial. The numbers I’ve seen indicate the Fed currently owns about 21% of the total issuance of Treasury coupon securities (T-Notes and T-Bonds). There are fewer long-dated Treasuries outstanding, though, so as you can see from the table below, the Fed actually owns a larger fraction of those securities.

What happens when you shrink the float of a tradable security?

If you answered bigger moves and greater volatility then give yourself a prize. Why? Because when there is less of something available to trade, but volume isn’t reduced on a comparable basis, the market will move more rapidly, both up and down.

Now think about what happens when markets go into “risk-off” mode, as we’ve seen happen lately.  You have a large amount of money flowing into a market which has fewer securities available to purchase. Increased demand combined with decreased availability means rapid price appreciation in those securities, and thus rapidly falling yields. That’s why one needs to be a bit cautious when viewing the recent market moves.

So where from here?

Well, it’s going to depend in part on what the Fed does. Does the central bank continue buying enough long-dated paper to maintain (or increase) its fractional holdings? Or does it stop once Operation Twist is over and hold pat with current holdings, or buy at a slower rate?

The more explosive scenario where yields are concerned is a combination of the Fed slowing or halting its purchases and the risk aversion bid coming out of Treasuries. The Treasury isn’t going to stop auctioning new debt any time soon, so we would end up with greater supply and decreased demand –both from the market and the Fed – that could send rates soaring.

Even if the Fed does keeping buying, the reduced float means we’re likely to continue to experience above volatility jumps on risk-related events for the foreseeable future. The impact of a decline in risk aversion would be a little less impactful, though, because the Fed would still be a demand factor.

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

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I bet right about now Jamie Dimon at JP Morgan is quite pleased to have the Facebook fiasco all over the news to take some of the spotlight off his little derivatives problem. As I write this (Tuesday morning), JPM is up 5% and FB is down nearly the same amount on the day. Personally, I think there’s way too much being made of the whole Facebook IPO story – though I do think the NASDAQ system problems is an interesting story, especially after the BATS failed IPO a little while back – but admittedly the rest of the news has gotten rather stagnant. I actually begged CNBC via Twitter on Friday to talk about something, anything, but Facebook, but struggled to come up with a good alternate subject.

Naturally, there’s a blame game going on as to whose fault it is the stock has taken a dive. We can never really know how things would have turned out if the NASDAQ system had functioned properly, but that won’t prevent folks from trying to do so. Finding someone to blame, of course, is a favorite pastime these days. Traders certainly do it when they take losses. After all, it can’t be my fault I lost money on my position. It must be those evil banks, unethical brokers, or speculators gone wild (unless, of course, they are moving prices the direction I want).  Yes, I am a speculator. Obviously, I’m talking about the other speculators, though – especially the ones with computers faster than mine. Yeah, the high frequency guys. It’s all their fault! They’re preventing me from moving out of the 99% and in to the 1%. Something really needs to be done about them.

Thankfully, today we’ve returned to the on-going back and forth between European central bankers and political leaders over what to do about the mess. It’s kind of refreshing after the all-Facebook-all-the-time chatter. Everybody seems to want Greece to stay in the euro, but it looks like we won’t find out until the middle of June as to whether the Greek people share that view. You’ll notice the German rhetoric on the subject of austerity and whatnot has cooled considerably. Could that be because suddenly they aren’t doing all that great either and the weak euro that’s coming out of all this actually tends to help Germany more than most on the export side of things?

Then there’s the on-going question of whether the US can remain out of the fray and avoid too much in the way of economic damage from all the European issues. I’m moving to England in the fall to start work on a PhD, so you know I’m looking for the dollar to go on a fantastic run higher to make my greenbacks go farther. Unfortunately, the UK retained the pound rather than join the euro. The photo going around of David Cameron with arms raised celebrating Chelsea’s performance against Bayern Munich in the Champions League final on Saturday (at last an English team beat a German one in penalties!)  alongside a much less enthused Angela Merkel could just as easily represent the British feeling about having their own currency through all the mess.  I’m hoping the Bank of England decides to do more QE. That ought to sink the pound.

In the meantime, back to my charts.

Oh look! There’s a cup-and-handle setting up on the weekly USD Index chart. Maybe the markets will help me get cheaper pounds without the QE.

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

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Ain’t it always the case that an exchange rate rallies into your trip, then starts falling after you’ve spent the lion’s share of the money? GBP/USD did that to me. It was looking so good early in January when the rate was down the low 1.50s, but by I time I left for my trip to England last week the rate was looking at testing 1.60. What day did the market peak? The day I checked out of my longest hotel stay, of course (insert your favorite string of curse words here).

What’s even more annoying is that GBP/USD really looks like it’s set up for a tumble.

On the weekly chart below we can see the clear support along the line going back to the lows from September 2010 near 1.5300. That was broken during the last leg down, but the market quickly reversed back higher. It hasn’t been able to push those gains to even create a test of the November peak, however, so the pattern of lower highs and lows since the 2011 highs remains in place.

These lower highs are also building a head-and-shoulders type of pattern on the chart. If we consider the peak of the pattern to be about at 1.6735, that gives us over 1400 pips in downside projection using the head-to-neckline measurement. A simple target would thus be about 1.3900. This is quite aggressive given the likely support above 1.4000 based on the 2010 lows, but it does provide a fair bit of scope as to the type of damage that could be done should GBP/USD manage a sustained break of 1.5300.

So what’s the catalyst for that kind of action? The BoE has already announced GBP50bln of additional QE. That has largely already been priced in and the market isn’t looking for any big additions at this point. The biggest risk factor at this point is a crank back up of the risk-off market psychology that would drive the dollar higher. If we see the S&P 500 fail to overcome the 2011 highs as part of the current rally, that becomes a very real risk.

This couldn’t have happened a bit sooner?

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

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Asaf did a bit of a ranting in his recent Are you listening to the “Experts” post. That’s encouraged me to get something off my own chest as well, something along the same lines.

You see, I spend my day watching the markets and listening to the folks on CNBC trying to explain what’s driving the markets. I use the term “trying” intentionally because they certainly aren’t getting it right in many cases. The one I keep hearing is that the movement in the dollar is driving the action in the stock market. Stocks rally on a weak dollar. Stocks fall on a strong dollar. Give me a break!

Stocks/Dollar Linkage

Let’s first take a look at the rolling 1 month correlation between the stock market and the dollar. The chart below compares the performance of the S&P 500 to that of EUR/USD over the last year.

First thing to notice is that the two markets have swung back and forth between being highly positively correlated (stocks and dollar moving in opposite directions) and pretty negatively correlated (stocks and dollar moving in the same direction) several times. Moreover, in 2010 they haven’t held correlations on either side of the range for very long before swinging back in the other direction.

More importantly, though, correlation does not mean causation. Just because US stocks and the dollar are going in opposite direction, as has been harped on so many times in the media, it doesn’t mean one is causing the other. It more likely means they are both reacting to the same underlying factors.

The Same Driver, Different Actions

Think about the stock/dollar relationship. What would cause stocks and the dollar to move at the same time? That would be money moving into the dollar from abroad and being invested in the stock market, or the reversal of that process. In either case stocks and the dollar move in the same direction.

Now why would stocks and the dollar move independently? Stocks could move because of action involving money already in dollars – US data, earnings releases, interest rate expectations, etc. The dollar could move because of money being exchanged for trade purposes or investment activity outside stocks (Treasuries, real estate, etc.).

So what have we been seeing in the markets over the last year or so? We’ve seen risk aversion trading in some cases. That’s when money piles into the USD as a safe haven. It doesn’t go in to stocks. It goes into Treasuries. At the same time, nervous investors already in dollars are taking money out of stocks and putting them in to safer investments. So what we have is one motivating factor (risk aversion) causing stocks to fall and the dollar to rise basically independent of each other, but in a correlated fashion.

We’ve also seen the QE trade in the dollar. That’s where folks move money out of the dollar for fear that increased money supply via the Fed printing money to purchase securities will lower the greenback’s value and lead to inflation. It’s simple supply/demand analysis. When you increase the supply of something you decrease its value. QE is seen as increasing the supply of dollars, so the USD’s value drops. The QE trade causes money to flow out of the dollar, which means foreign flows (on net) cannot be moving into stocks, so we have no dollar-related reason for stocks to rise. They are moving for their own reasons (better earnings prospects, lower interest rates, etc.), but again, linked to a similar underlying driver.

Follow the Money

My point is this: think these things through. If you are looking at the markets from a fundamental point of view you need to think in terms of the flow of money. Investment flows are a big driver, so you have to understand the implications of different events and development in those terms to really understand what’s underpinning the market’s action. Follow the money. It’s a simple thing folks on CNBC don’t seem to be able to do.

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results.

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.