Re: [A-List] Interest-rates and short squeezes

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

What the short-sellers failed to take into account was that foreign
central banks must buy between $1 - 2 billion each day of government
bonds to park their additional foreign exchange reserves from the US
trade deficit.  This is a factor that was absent in 1994 when the bond
market collapsed from the Fed raising the Fed Funds rate in quick
succession.  Because government bond market participants grossly
misjudged the Treasury market's chance to rally in the face of Fed
tightening and stubbornly hanged on to conventional moves expecting a
killing and throwing in the towel only when it is too late, the rush to
unwind pushed bond prices even higher from techicals.  On Wednesday,
September 22, the 10-year-note fell below the psychological 4% (3.98%)
for the first time since April when the Fed made its third tightening of
the year.  That shifted market sentiment,  and traders decided to stop
throwing good money after bad to support of Greenspan's fantasy of a
recovery, and treated the rise in bond prices as a signal to buy more.
It was the market's vote that the economy will not be heading north for
a while.

Short-selling began four months earlier, when the non-farm payroll surge
by 308,000 in March suggested that an end to the three year bull run on
bonds was in sight. In June, the 10-year-note yielded 4.9%, only a few
weeks before the Fed raised Fed Funds target for the first time in four
years.  Surely bond prices had no place to go but down with yields going
up, so figured the smart money.  Morgan Stanley announced on Wednesday
Sept  22 that its fixed income  trade revenue fell  35% in the quarter
ended  August 31 from previous quarter due mostly to betting wrong on
bond prices falling and rates rising.  With current inflation data, the
neutral rate for Fed Funds is 3.5% and at the current 1.75%, the Fed
Funds target would have to double and according the Greenspan, it may
take a long time to reach that level.  But the longer the Fed takes to
bring Fed Funds rate back to neutral or to a restraining level, the
bloodier will the crash of the bond market when it happens.  And it will
happen.  Life does not stop merely because some short-sellors lose
money.  Smart money often loses coming and going, which is the
definition of a crash.

Henry C.K. Liu


Hudsonmi@xxxxxxx wrote:

> I hope you guys aren't missing the big story these days about the
> growing conflict within the finance-capital sector - Morgan Stanley
> Dean Witter, Goldman Sachs, Merrill Lynch, etc.
> The story concerns the course of interest rates, and hence, bond
> prices. Last week Morgan Stanley reported sharply lower earnings as a
> result of bad guesses on the course of interest rates, leading to
> options and derivatives trade in Treasury-bond futures.
> Much of Wall Street saw that the Fed intended to raise short-term
> interest rates, and concluded that long-term rates would also rise.
> This meant that prices for existing bonds would decline. Investors
> sold hundreds of billions of dollars of Treasury bonds short - that
> is, they promised to deliver them at a later date at a pre-agreed
> price, expecting to be able to buy these bonds at a lower price as
> interest rates rose.
> But long-term rates did not rise. Short-term rates rose, but there was
> an immense demand for 10-year Treasury bonds. The upshot was a "short
> squeeze": Buyers bought bonds because they knew that as prices rose,
> the short sellers would have to buy bonds to cover their positions
> (that is, their promises to buy and deliver these 10-year Treasury
> bonds). The larger the short-sale volume grew, the more demand was
> scheduled to come into the bond market, bidding up prices. (A similar
> price rise occurred in 1994.)
> The upshot was something like George Soros's raid on Britain's attempt
> to stabilize sterling. It all became a question of who could raise
> more money: buyers or sellers.
> Yields yesterday on 10-year Treasury bonds fell below 4%, despite the
> fact that the Fed raised short-term rates earlier this week.
> Meanwhile, the Financial Times speculates on whether lower long-term
> Treasury rates will lead mortgage rates to decline, prompting
> re-financing. If this occurs, FNMA and GNMA will receive lower
> payments, but have to pay out high payments to THEIR bond-holders.
> Looks interesting.
>
> Michael