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• The Fed has begun to tighten, what`s next for markets?
• Bullard was the only person at the FOMC who has spoken publicly, and he says “This a more hawkish Fed”
• World War Z – when I read the film review, why did I think of High Frequency Trading?
• Tim Duy: The primary consideration for scaling back asset purchases is the calendar, not the data
• Japan’s Government Pension Investment Fund (GPIF) to soon start acquiring more foreign assets
• Best trade this week: Long USDJPY
• When will the Federal Reserve begin winding back asset purchases?
• ForexLive Americas wrap up: Canadian dollar takes a tumble
• CFTC data: The `smart money` was positioned terribly into the Fed
• Some pre-weekend good vibes
• Hilsen-rebound fades with the week winding down
• The Fedwatcher with sources says Fed not shocked
• ECB’s Noyer taking a page from Hilsenrath’s playbook
• WSJ’s Hilsenrath: Market may be misreading the Fed’s messages
• USD/JPY finding its legs
• Euro breaks 1.3100
• Industrial metals plunging and it’s not about the Fed
• Job opening: Bond King
• European equity close: At the lows of the week
• Bullard says Fed should focus on inflation not unemployment

The Fed has begun to tighten, what`s next for markets? Posted: 22 Jun 2013 12:05 AM PDT Lessons from past Federal Reserve tightening cycles Since Ben Bernanke's warning this week that QE will "taper", markets have taken fright. The S&P500 lost 3.5% from highs Wednesday to close on Friday, while the German DAX lost 5% and the UK's FTSE 3.7%.  Continuing an on-going trend, emerging markets lost more, with The Hang Seng down almost 6% before some recovery on Friday.  Bond markets have already had a bad month in May and the rate on the benchmark ten-year US Treasury is now up to 2.5% — the highest since mid-2011. Yet none of what Ben Bernanke said should be a surprise. There have been murmurings from the Fed about the approaching end to QE since the beginning of the year at least. And clearly interest rates cannot stay low forever.  With a strengthening economy, the "ZIRP Experiment" will end and the "Great Normalisation" will begin. So why have markets reacted as they have?  Firstly because talk is not the same as reality. And secondly, when everyone is having a party, no one wants to be the early to leave in case they miss the fun.  Fixed income has had one hell of a party – an eighteenth, twenty-first, stag, hen, wedding and divorce party combined.  Its been a 30-year bond bull market party and as most of us have experienced, the longer the binge, the more painful the hangover. So what can history teach us about the morning after? There have been two periods during the past 25 years when the Fed has tightened considerably – 1994 and 2004.  What can we learn from them? In 1994 Ace of Base occupied three top ten positions in the US Billboard charts and that`s still my favourite. I was 24 and two years into my life at Goldman but the Fed almost cost me my career. Investment banks were taken by surprise by the Fed's tightening, suffered huge losses in their fixed income divisions and by the end of the year, staff were being let go. Orange County, California was the naked swimmer that got caught when the tide receded and went bust after it lost $1.7bn from debt and derivatives (but it wasn't the only one). On February 4,1994 the Fed increased its key rate by 0.25% to 3.25%.  Markets were spooked and the Dow Jones fell almost 2.5% on the day. The tightening continued and by the middle of 1995, eighteen months later, the Fed Funds rate finally doubled to 6.00%.  The scale of tightening was unexpected as according to one newspaper report from the time, only modest rate rises were predicted – 3.5% by end 1994. What is interesting is that after the initial shock, the stock market didn't really move – the S&P was about flat for 1994.  The big move though was in long term interest rates – 10 year Treasuries yields increased from 5.75% to 8% that. But as soon as investors sniffed an end to the rate increases, the stock market started to rise and the 10-year yield fell back again by the end of the next year – 1995.  Inflation had been controlled thanks to rate increases and that was good for bonds; growth was strong and that was good for equities. Fed funds rate So what about the experience in 2004?  The Fed tightened Fed Funds rate from 1.00% to 5.00% in 2006.  During this period the US stock market was pretty strong – the S&P500 started 2004 at about 1100 and ended 2006 at almost 1300, a rise of around 20%.  What is interesting is that the long term interest rates were much less affected by the Fed.  The yield on ten-year Treasuries, albeit a bit volatile, was effectively flat at 4.5% over the period. The first thing these examples show us is that equities do not have to fall as rates increase. In fact they can rise as higher rates are the monetary response to a stronger economy. Secondly it teaches us that the effects on the yield curve – the term structure of interest rates – can be very different. In 1994, the ten-year bonds collapsed, but in 2004-06, ten-year yields were essentially unchanged. There is a major difference in 2013 – QE.  It down down ten-year US Treasury yields as low as 1.4%, way below the levels of 1994 (5.75%) and 2004 (4.5%). Secondly by pulling all rates of return down, it has forced investors who would normally prefer the relative safety of bonds into equities.  Many believe this has "artificially" inflated stock prices – it is visible that stock markets are pushed higher after QE. 10 year yield history So although 1994 and 2004 show that Fed tightening need not be catastrophic for either bond or stock markets, this time it's different. We do not face an "ordinary" tightening cycle because the monetary stimulus has been exceptionally large. However the phrase "this time its different" always makes me nervous as it tends not to be true. So let's look at the differences between '94 / '04 and now. Firstly the Federal Reserve is much more transparent about policy than it has been in the past. It realises it must handle the adjustment to more normal rates exceedingly carefully.  This means bond markets are much less likely to be spooked and surprised as we saw 1994. Secondly, equities are not that expensive and companies have spent the years of the crisis restructuring, taking costs our and loading up on cheap debt. Thus corporate earnings growth from a recovering economy should be strong. Thirdly and this is a bit of a technical / mathematical argument, but any bonds issued in the last five years will have lower coupon payments than those issued in the 1990s and 2000s. Prices of low coupon bonds are super sensitive to interest rates moves. So when interest rates increase as we know they will, all these bonds issued in the last 5-7 years will fall a lot more than the higher coupon bonds of in 1994 and 2004. I was reminded of the super sensitivity of low coupon bonds to interest rate risk by an FT piece written by an M&G bond vigilante.  And this highlights another thing to remember when reading people's opinions.  They talk their own book.  No bond fund manager is going to tell you how bad its going to be as they will be talking themselves out of a job.  The call to sell bonds may as well be a call to "Fire Me". To explain that the bond sell off will be a lot worse this time around because of low coupon bonds but still end up bullish is explained by the fact he is running the bond fund business!  Also most bond fund managers, traders, sales people and brokers have only experienced one type of market – one that always goes up.  And this never ending decades old  bull market has taught them that every set back has been a long term buying opportunity.  That is dangerous. Along the same lines, I looked up all the CEOs of investment banks to determine their backgrounds.  The last person you want running an investment bank at the moment is someone from a fixed Income-only-ever-a-bull-market-buy-at-every-opportunity CEO.  Thanks to the financial crisis, fines, bankruptcy and scandal, most CEOs have been replaced with corporate banking, wealth management types.  However the one exception is Goldman Sachs whose CEO, Lloyd Blankfein came from a commodities and fixed income trading background.  Ex-colleagues tell me the firm has been taken over by the Bond Boys.  Clearly money equals power and the money has mostly been made in the fixed income, currency and commodities business for many years.  Someone who is only ever used to a buy at every opportunity market is not ready for the reverse. So my opinion?  Bond markets will be crushed when rates go up and normalise.  After a 30 year bull market, and rates now so low, it is a mathematical certainty. But equities might be able to continue to perform if the earnings growth is good.  Yes, equities are valued against bonds – there is a  relationship between dividend and bond yields.  But remember dividends are not fixed, like bonds, they increase with profits. I started with a song from 1994, so let's end with one from 2004. To be brutally honest I am not that keen on many of Billboard hits from that year, but this is a good one. There shouldn't be a correlation between great years of pop and the US bond market although it wouldn't surprise me if a hedge fund supposed alpha seeker found one. Data mining throws up all sorts of weird nonsensical relationships.  Given that the predicative capabilities of most economists and strategists are dire, maybe forecasting the bond market using musical taste could be a way forward… So then you need to decide in 2013 is a great musical year like `94 or not so great like '04. Thoughts please….

Bullard was the only person at the FOMC who has spoken publicly, and he says “This a more hawkish Fed” Posted: 21 Jun 2013 10:18 PM PDT More from Tim Duy (I posted another piece earlier from his blog, which needs to be read along with this post). Duy says that the only person who was in the room Tuesday and Wednesday who has spoken about the meeting so far is St. Louis Federal Reserve President James Bullard, and he has given a clear message. When asked: " Is this a more hawkish Fed today than it was a week ago or a month ago?", Bullard replied: Based on Wednesday's action, I would say it is. (Duy also makes another good point, that it is the flow of purchases from the Fed that is important, much more so than the stock of purchases. Article is here).

World War Z – when I read the film review, why did I think of High Frequency Trading? Posted: 21 Jun 2013 09:49 PM PDT World War Z is a zombie-movie with a difference. Instead of being slow-moving, lumbering beasts, the zombies move really fast. I don't know what it is, but when I read this piece of the review: worldwide plague that turns people into athletically inclined zombies that can scale walls and overtake cities in minutes. Soldiers shoot down some of the zombies, but without a weapon, humans don’t stand much of a fighting chance. “With fast-movers, you really lose the ability to strategize … It brought to mind HFT. Looks like a fun movie, regardless. Trailer:

Tim Duy: The primary consideration for scaling back asset purchases is the calendar, not the data Posted: 21 Jun 2013 09:41 PM PDT St. Louis Federal Reserve President James Bullard dissented from this week's FOMC decision. Tim Duy, one of my most valued reads says Bullard's dissent is an 'eye-opener', that the Fed is 'no longer comfortable with asset purchases and want to draw the program to a close as soon as possible.  And that means downplaying soft data and hanging policy on whatever good data comes in the door.' Duy concludes (bolding mine): The Fed changed the game this week.  Bernanke made clear the Fed wants out of quantitative easing.  While everything is data dependent, the weight has shifted.  The objective of ending quantitative now carries as much if not more weight than the data.  Market participants need to adjust the prices of risk assets accordingly. Bottom Line:  I think the question is not how good the data needs to be to convince the Fed to taper.  The question is how bad it needs to be to convince them not to taper.  And I think it needs to be pretty bad. Duy’s view is a contradiction to much of the prevailing market opinion – read that bolded part again. If Duy is correct, and his view takes hold in the market, the market repricings we have seen so far are only just the beginning. Who said it was going to be a quiet summer?

Japan’s Government Pension Investment Fund (GPIF) to soon start acquiring more foreign assets Posted: 21 Jun 2013 09:14 PM PDT OK, time for me to flog a dead horse once again. Here goes: Despite the recent reversal of anticipated flows to EU bonds from Japan's unprecedented monetary easing, developments in Tokyo could yet lead to substantial inflows to Europe from Japanese institutional buyers. I can't remember when I started saying this outflow from Japan was going to happen, it was quite a while ago. Colin Reimer (in the comments) was pretty quick to say it wasn't going to happen. Colin was right. I've been … ummm …. I believe 'early' is the popular euphemism for 'wrong'. Yeah, “early” … thats what I've been. OK, so any time now, according to Nomura: Japan's Government Pension Investment Fund (GPIF) to soon start acquiring more foreign assets GPIF moving, partly due to pressure from Japanese PM Abe Partly due to recent volatility in JGB market GPIF to cut its allocation to domestic bonds from 67% to 60% of its ¥112 trillion ($1.17 trillion) total assets Will boost holdings of domestic stocks from 11% to 12% Allocation to foreign stocks will rise from 9% to 12% Allocation to foreign bonds from 8% to 11% Watch me pull a rabbit out of a hat … This time for sure!

Best trade this week: Long USDJPY Posted: 21 Jun 2013 05:26 PM PDT Long USDJPY and short NZDUSD were neck-and-neck as the biggest movers this week, gaining about 3.5%. The rebound in USDJPY completely wiped out the losses from the week before and sets up a continuation higher as USDJPY longs remain the main theme of 2013. USDJPY fell almost precisely to the 38.2% retracement. With US yields rising and the Fed promising a stronger recovery, the upside looms. Further confirmation would come on a rise above last week`s high of 99.28. The decline fell to the 38.2%

When will the Federal Reserve begin winding back asset purchases? Posted: 21 Jun 2013 05:23 PM PDT The Fed: "anticipates that it would be appropriate to moderate the monthly pace of purchases later this year", "If the incoming data are broadly consistent with this forecast" So, what's the Fed's forecast? And what do we need to happen to see an improvement such that the Fed begins the wind-back? Bill McBride at the Calculated Risk blog works through the Fed's projections here. McBride uses three measures to track the incoming data and assess if it is broadly consistent with FOMC projections. 1. GDP – it will need to pick up in the second half of 2013 2. Unemployment – McBride says "so far the unemployment rate is tracking the forecast" (He notes that most of the decline is due to a decline in the participation rate and that for the u/e rate to continue to fall at current participation rates then job growth will need to accelerate to meet FOMC projections) 3. Prices (using the Personal Consumption Expenditure data, the Fed's preferred measure of inflation). PCE is significantly below the FOMC target of 2%. Core PCE prices, too, are also below. McBride concludes that: It is possible that the FOMC could start to taper QE3 purchases in December, but it would take a  pickup in the economy. (September tapering is less likely, but not impossible – but the pickup would have to be significant).

ForexLive Americas wrap up: Canadian dollar takes a tumble Posted: 21 Jun 2013 01:21 PM PDT Forex headlines for June 21, 2013: Canadian CPI +0.7% yy vs 0.9% exp Canadian May retail sales +0.1% vs +0.2% exp Bullard says Fed should focus on inflation not unemployment WSJ's Hilsenrath: Market may be misreading the Fed's messages ECB's Noyer says the market reaction to the Fed's comments is excessive MNI: Fed is not shocked by the market reaction Merkel says there won't be a European superstate Greek govt has sufficient majority to lead out of crisis – spokesman S&P 500 up 0.3% to 1592, down 2.1% on the week US 10yr yields rise 40bps on the week, largest weekly rise in a decade AUD leads, CHF lags The euro extended losses as US traders rolled in, falling as low a 1.3099 from around 1.3200 at the start of trading. It bounced to 1.3160 shortly after Europe went home as the Hilsenrath story hit but it has since drifted back to 1.3126. Cable was remarkably resilent on Thursday but it finally cracked just before US trading as it slid below 1.5475 and continued 100 pips lower to 1.5368, just below the 55-day moving average. Bids ahead of 1.3550 sparked a rebound to 1.5455, along with the Hilsenrath story and better sentiment in stocks. Last at 1.5427. USDJPY was choppy but directionless. The lows were at 97.32 as the S&P 500 dove in mid-morning trading. The continued rise in Treasury yields helped a recovery but it couldn`t get through 98.00. Post-Hilsenrath it slipped back to 97.60. The Canadian dollar dropped after the double-whammy of soft retail sales and low inflation. USDCAD ripped through the 2013 and 2012 highs to 1.0489 and then leveled off. Last at 1.0451. The bounce in gold was uninspiring as it gained $10 to $1294 but was down $100 on the week.

CFTC data: The `smart money` was positioned terribly into the Fed Posted: 21 Jun 2013 12:46 PM PDT Futures market speculative positioning data from the CFTC Commitments of Traders report as of the close on Tuesday, June 18: EUR net long 20K vs short 7K prior JPY net short 61K vs short 73K prior GBP net short 20K vs short 54K prior AUD net short 64K vs short 63K prior CAD net short 26K vs short 36K prior NZD net long 2K vs long 2K prior CHF net long 5K vs short 21K prior Dollar Index net long 14K vs 43K prior Gold net long 44K vs 59K prior Traders were bailing out of US dollar longs ahead of Wednesday`s FOMC decision. Speculative money has been absolutely whipsawed in the past few weeks. The market was stuck in money-losing euro shorts for much of that time and then went long ahead of the Fed. Since Tuesday`s close the euro is down more than 250 pips. It`s a similar story for cable shorts, which finally paid off. The good news is that with the market long-to-neutral on the euro, it will be easier for it to slide — something I pointed out on Monday. JPY positioning has also pulled back form the extreme and that could make gains a bit easier (although I suspect longs have been piling in since Wednesday).

Some pre-weekend good vibes Posted: 21 Jun 2013 11:50 AM PDT A few stories that are putting a smile on my face headed into the weekend. I had a good week in the market so I`m ready for the weekend. A couple things in the news made me optimistic for the summer. The first is this story about right-wing politicians turning away from mass, long-term incarceration of non-violent prisons. This would be one of the easiest ways to trim budgets and expand the work force. They are also talking about doing more to rehabilitate drug addicts, rather than imprisoning them. For air travelers, there is some great news as the FAA is expected to relax the ban on using electronics during flights. Finally, here is and amazing video of 8 men reacting to catch an infant girl falling from a balcony.

Hilsen-rebound fades with the week winding down Posted: 21 Jun 2013 11:10 AM PDT The WSJ Fedwatcher seems to have lost his magic. Stocks are back in negative territory and yields at the highs of the day. If this market was going to rebound today, it would have happened on those headlines. That said, there is an entire weekend ahead for the market to re-evaluate and put things into perspective.

The Fedwatcher with sources says Fed not shocked Posted: 21 Jun 2013 10:36 AM PDT Before the Hilsenrath story, Steve Beckner (the dean of Fedwatchers) posted a story on MNI, citing sources at the Fed. He reported that the Fed is not shocked by the market reaction to the taper signal but could delay tapering if worse financial market conditions hurt the economy. The Hilsenrath story is getting all the play but Beckner has been around a long time. There isn’t a really clear takeaway from Beckner but it’s less supportive than Hilsenrath although both of them focus on the economy.

ECB’s Noyer taking a page from Hilsenrath’s playbook Posted: 21 Jun 2013 10:18 AM PDT ECB’s Noyer says the market reaction to the Fed’s comments is excessive European economy is lagging US ECB ‘not on same timetable’ as Fed

WSJ’s Hilsenrath: Market may be misreading the Fed’s messages Posted: 21 Jun 2013 09:51 AM PDT WSJ headline. Overlooked dovish signals in Bernanke press conference The market isn’t even waiting for the text of the story, selling dollars. Update: The story is out. It recaps some of the more dovish lines from Bernanke’s press conference, including: "If you draw the conclusion that I've said that our policies, that our purchases, will end in the middle of next year, you've drawn the wrong conclusion, because our purchases are tied to what happens in the economy … we have no deterministic or fixed plan." Hilsenrath also points to Bullard’s comments today, hinting that other Fed officials may have been unprepared for the firestorm in markets. The only statement from a Fed official since the meeting has come from Mr. Bullard . Mr. Bullard was clearly worried about how the market would respond to the Fed's decision to announce a timetable for winding down its bond buying. He "felt that a more prudent approach would be to wait for more tangible signs that the economy was strengthening and that inflation was on a path to return toward target before making such an announcement," according to his statement. Given the market turmoil that has since ensued, other Fed officials might now be wondering if he was right. Lately, Hilsenrath wields enormous power in markets. It reads like a recap but many market watchers think the Fed sends signals through the WSJ Fedwatcher and this could kick off a retracement of some of the moves since the FOMC.

USD/JPY finding its legs Posted: 21 Jun 2013 09:51 AM PDT USD/JPY is at the highest since Asian trading as it pokes toward 98.00. A better tone for stocks is helping with the S&P 500 back in positive territory at 1589 from a low of 1577. Beyond the big figure, yesterday’s high of 98.29 is resistance. The consolidation over the past day has been healthy and the market looks like it could be getting set for another leg higher.

Euro breaks 1.3100 Posted: 21 Jun 2013 09:33 AM PDT The dollar longs continue to do the rain dance with 1.3099. Rumored stops below 1.3100 haven’t materialized yet but it could just take a few more pips.

Industrial metals plunging and it’s not about the Fed Posted: 21 Jun 2013 09:23 AM PDT Nickel is down 26% since February and the lowest since May 2009. Copper is down 19% since February and yesterday hit the lowest since August 2011. Aluminum down 17% since February and at the lowest since August 2009. Oftentimes supply issues can skew some of the base metals but when they all point in the same direction and hit long term lows, it’s a major warning sign for the global economy. The headline story is the Fed but these drops have almost nothing to do with tapering (although USD strength weighs). The story is slowing/stalling growth in emerging markets. The Australian dollar has been punished for the past month but it could have much farther to go.

Job opening: Bond King Posted: 21 Jun 2013 08:50 AM PDT It’s been a tough year for Bond Kings. Most people consider PIMCO’s Bill Gross the Bond King but his reputation is taking a pounding after stories like this: Gross's flagship, the world's largest mutual fund, lost 1 percent Wednesday and was down 2.2 percent for the year through Wednesday the worst of 19 U.S. total return funds with at least $2 billion in assets, according to data compiled by Bloomberg. The other bond king is Jeff Gundlach from DoubleLine Capital but the Business Insider notes that his batting average is quickly falling. I really do not think you're going to see 2.50 on the ten-year any time in 2013. The problem isn’t the managers, it’s that there was really no way to make money on the long side of the bond market for the past month. Gross is saying the market is misinterpreting the Fed’s intentions. He highlights the conditionality of tapering and warns that inflation and growth objectives won’t be met. That might be true but the market can stay irrational for longer than his reputation can stay intact.

European equity close: At the lows of the week Posted: 21 Jun 2013 08:34 AM PDT The S&P 500 is at the lows of the day as European stocks limp into the weekend: UK FTSE -0.4% German DAX -1.4% French CAC -0.8% Spain IBEX -1.7% Italy MIB -1.4% Three consecutive weeks of declines for all the European bourses. It’s not a good sign when a market closes at the lows of the week.

Bullard says Fed should focus on inflation not unemployment Posted: 21 Jun 2013 08:23 AM PDT Comments from Bullard in a Bloomberg interview: Fed may need to increase QE if inflation slows Reduces his 2013 growth forecast to 2.8% from 3.0% Update: BBG later corrected his forecast to 2.6% Rising rates pose a headwind to economic growth FOMC forecasts suggest deflation is not transitory Disinflation is prompted by China slowdown and Europe Financial conditions have tightened He makes some good points and I wonder what the rest of the FOMC is seeing to make them so complacent about inflation and optimistic about the recovery. US CPI year-over-year

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