Tapering Is Not Tightening

 | Jun 21, 2013 | 1:00 AM EDT  | Comments
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Sometimes, when the markets look their worst, it is precisely the best time to be a buyer. The post-Fed blood bath in the Treasury market might be one of those occasions. Although the Treasury market offers little in the way of yield, there could be an argument for price appreciation and, better yet, a hedge against what are typically highly volatile summer equity markets. Naturally, some would argue that Treasuries themselves can be a dangerous investment should investors all run for the exit all at the same time. And this is exactly what has taken place in recent weeks.

I will admit that I began getting positive in Treasuries far too early into this selloff, but everything I look at brings me to the same conclusion. The recent weakness in government backed securities is more of an emotional reaction than a fundamental one. After all, as recent as Wednesday's press conference the Fed has made no actual changes in its monetary and stimulus policy; they will continue to be large buyers of securities. When they do begin to "taper" at some point much later this year, or into next, it is being described by Bernanke as "pulling the foot off the gas but not braking".

Markets tend to be forward looking, so the fact that traders are reacting to expectations of future Federal Reserve actions isn't surprising. Nonetheless, as it often the case when it comes to front-running the Fed, it seems likely the markets have gotten ahead of themselves.

We have seen this phenomenon before. Anybody trading Treasuries in 2008 at the time the Fed began mentioning the QE program, will tell you that Treasuries rallied enormously before the Fed ever spent a penny buying securities. However, once the market was done reacting to the news, the rally fizzled and prices went into a free fall (see the chart below).

 Source: QST

We view today's environment in similar light, but in the opposite direction. The Treasury market is selling off in dramatic fashion and the Fed hasn't even reached to tighten its "murse" strings (a murse is a man-purse for those of you in the dark) yet. If the same pattern holds true, the selling should eventually dry up and prices will revert higher to a more fundamentally sound, yet Fed-induced, level. The Treasury market is being manipulated by a trader with arguably the biggest pockets of all, the U.S. government (not to mention that PIMCO's Bill Gross has announced he would a buy Treasuries on this dip).

Keep in mind that the seasonal low in the Treasury market typically comes in early to mid-June. Despite being a little beyond the typical turn-around point, seasonal buying pressures should at least keep some sort of floor under pricing.

During phases of liquidation, it is common to see money flowing from one asset class and into another. However, during Thursday's session, investors were liquidating anything and everything. They appear to have been content with holding cash, but if we see continued volatility and uncertainty in risk assets, the money could eventually flow back into the safety of Treasuries simply because it will have nowhere else to go.

Technical analysts will point out that Treasury prices are sharply oversold; in fact, technical oscillators are as overstretched as they have been since February of 2011, which was followed by a historically large rally into October of the same year (see the chart below).

Similarly, Treasury bonds and notes are trading at levels that were supportive in years past; specifically, they are matching the lows made in October of 2011 and then again March of 2012. On each of those occasions, we were in a similar environment. Some of Wall Street's smartest and best were calling for an end to the Treasury bull and advising clients to steer clear of Treasuries. As we all know, those levels turned out to be the lows of the move. We suspect the odds favor a repeat time around simply because the Fed is actually buying more securities now than they were on the previous two lows at this level.

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