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There Is a Bull Market in Bonds Out There

The Fed Funds market is aggressively pricing three Fed interest rate cuts.


Before the infamous tariff tweet on May 5 that announced to the world that the Chinese trade deal was in trouble, December 2019 Fed Fund futures settled at 97.735 (symbol ZQZ19). That number may not mean much to the average investor, but to a futures trader it implied that the market was expecting the fed funds rate to be 2.265% at the time of settlement of the fed fund futures contract in December 2019 (2.265 equals 100 minus the ZQZ19 price). At the close of trading last week, the same futures contract predicted a fed funds rate of 1.745%. That means the market is aggressively pricing three Fed interest rate cuts.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The trillion-dollar question is: Will the market get these three cuts?

This question is worth trillions of dollars because in early November 2018, the 10-year Treasury yielded 3.25% near the low point of the ZQZ19 fed funds futures contract. Recently, that 10-year rate has been as low at 2.05%, so if one pressed a bet with maximum interest-rate sensitivity in the Treasury market with zero-coupon bonds, one would have seen the price of a zero-coupon ETF like ZROS go from $99 to $129 all while the stock market went down a lot and up a lot, but didn’t make any net progress in the meantime.

The correlation between zeroes and fed funds futures is rather telling as to what caused Treasury yields to drop so precipitously.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Personally, I do not believe the stock market will see the three interest rate cuts if there is a Chinese trade deal. While I thought there would be a Chinese trade deal before that infamous May 5 tweet, because the Chinese economy would suffer tremendously under heavy debt loads without one, it very well may be that the Chinese have decided to ultimately devalue the yuan and go ahead without a trade deal.

If the domestic situation in China is much weaker than official Chinese government economic statistics indicate, then devaluing the yuan without a trade deal makes more sense for the Chinese, as they would kill two birds with one stone: They create the necessary domestic inflation to service their mountain of debts and counter the effects of a 25% tariff. A yuan devaluation is not a complete antidote to a tariff, but it would make things a lot better for the Chinese, as it also inflates away some of their mountain of debts.

It would be unthinkable for The Donald to levy a 50% tariff, as in that regard he will be seen as unhinged and the initiator of the Second Great Depression, as much higher tariffs will be a big disruptor to global trade and will be guaranteed to cause a global recession. Did the Sun Tzu disciples in Beijing pull a rabbit out of their hat with the calculated failure of trade talks? I think we will know before the end of summer.

Political Judo, Sun Tzu-Style

If there is a trade deal – and that’s certainly a very big “if” – it is entirely possible that the present stock market volatility would have been just a trading range that digests the huge stock market gains from the Trump Presidency. This will very much be the case with the Fed on the sidelines and their balance sheet unwind coming to a close in 2019.

If there is no trade deal, it is also possible that the present trading range in the stock market is what they call in the trading business a “distribution top.” Under that scenario, the May highs in the stock market could turn out to be the highs for this cycle. If so, it would appear that the Sun Tzu disciples in Beijing used Mr. Trump’s own overselling of the likelihood of a trade deal against him, similar to the sport of judo, where one’s main weapon is using one’s opponent’s weight against him.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

To complicate matters further, there is a second geopolitical judo game being played out in the Persian Gulf. I would have felt a lot better if we did not have those tensions in the Persian Gulf so that the price of crude oil would reflect simple economic supply and demand dynamics and not the likelihood that the flow of oil from the Gulf could be choked off by exploding tankers and military activities against Iran. That way, crude oil prices would reflect the true situation in the Chinese economy, which the London Metals Exchange Index suggests is not all that great.

The owner of the damaged Japanese tanker reported drones just before the attack – not mines, as was previously reported in the press. Also, the damage to the tanker is above sea level, which is why it is still floating in the Gulf. Damage from a mine would have been below the waterline. While it certainly could be the Iranians, there are also a number of players in the Gulf region that would benefit from the U.S. striking Iran, so the theory that this is a “false flag attack” cannot be dismissed out of hand (see New York Times, June 14, 2019 “‘Flying Object’ Struck Tanker in Gulf of Oman, Operator Says, Not a Mine.”)

All this Gulf drama reminds me of the 1997 spy drama, Tomorrow Never Dies, in which fictional news mogul Elliot Carver drives a British ship off course by rigging its guidance systems and sinks it in order to provoke a military response from the Royal Navy against the Chinese. Those exploding tankers surely invite convenient parallels with the 1987 Tanker War, when Iran did use mines in the Persian Gulf.

But what if the Iranians did not fly those exploding drones?

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