I Remain Steadfastly Bearish on Bonds

 | May 30, 2017 | 12:00 PM EDT
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Bonds have caught a nice bid lately. The 10-year note future has rallied from $123 to $126 since the last rate hike back in March. The yield has fallen from 2.60% to 2.25%. Lots of bearish bond bets have been unwound.

Back in mid-March, right before the last Fed rate hike, speculators in the 10-year Treasury on the CBOT were net short 592,000 contracts. Fast forward to today: the specs are short just 236,000 contracts -- less than half. And if you look at leveraged money alone, which would comprise managed futures, hedge funds, etc., that cohort is only net short by 59,000 contracts. Practically nothing. That's a very large liquidation of those short positions in that time.

Why the covering of shorts?

The data has been mixed. Some economic reports reveal a strong or strengthening economy, while other reports have been on the weak-ish side. Corporate earnings were certainly stronger in the first quarter than anticipated. To sum up, I find no reason to hastily cover.

When it comes to my outlook on bonds, I remain steadfastly bearish, and here's why.

Rate adjustments are set by the monopolist, and in this case we are talking about the central bank, the Fed. The monopolist not only tells you what it is going to do, but its actions reinforce the trend in the direction of those actions.

Let me explain.

When the Fed is saying it's going to raise interest rates, that is a policy choice and it is telling you not to be long the bond market. By setting rates higher, the Fed is also inadvertently raising prices. I have been through this a million times. The cost of credit is reflected in the cost of all goods and services and while the Fed/gov't can set the price of anything it wants just by virtue of the fact that it can print money and buy what it wants at whatever price, it chooses interest rates as its tool for price policy.

On a side note, the Fed endeavors to "regulate" the economy and employment by juggling prices around. It's a very ineffective tool, but nonetheless, it's the tool that it uses.

When the Fed raises, it raises all price levels. It might then sit for a while and do nothing, but there is a limit to how much downside yields have after that, and there is also a limit as to how much upside bond prices have. Don't forget, the Fed is still in rate hike mode.

When the Fed hikes the next time, it raises the price level again, each time bringing prices to a higher plateau level. This goes on and on and on, and it creates a self-sustaining cycle that stays in effect until the Fed says it is going to reverse and go in the other direction.

Now, let me make this very important point. Since it is the Fed and not the market that sets rates, that means even if the economy went into recession, if the Fed still wanted to raise rates, rates would go up, not down.

For this reason, I have absolutely zero confusion or concern about the direction of rates and bond prices. Rates are going up, and bond prices are going down until the Fed says it's done.

I'm short bonds and remain short until the Fed says to me that their next policy direction is down. I suggest you do the same. You know that old saying, "Don't fight the Fed?" Well, it definitely applies to rates and bond prices, too.



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