Pushing On A String or the Last Bubble?

``Thank goodness I have a lot of math, cause thru the clever use of differential equations, I can calculate that the Fed has only four more Shock and Awe 75 bps cuts, plus a Shock (but no Awe) 50 bp left.”-Barry Ritholtz, Is the Fed A Paper Tiger?

This leads us to our next observation: What if the Fed policy fails to stimulate the economy and the market?

Figure 2: contraryinvestor.com: Last Bubble Standing?

Contraryinvestor.com brings out an important point that long term yields see Figure 2, particularly 30 year (topmost) and 10 year yields (below 30 year) have almost reached levels when Fed rates were pegged to a 4 decades low in 2003-2004 (shaded area) signified by the short term yield at the lowest pane.

This shows how the treasury markets have priced in extensive fear or panic more than the underlying economic potentials. To add, treasuries have been behaving as alternative safehaven instruments arising from the lack of highly liquid instruments. Remember many AAA instruments have been impacted by the credit crisis due to financial engineering or packaging of AAA papers with garbage and got labeled as AAA by ratings agency, hence the recent downgrades and attendant losses.

Given the recent intense discounting action, yields of the treasuries appear unlikely to fall further unless markets will price in a massive recession or something equivalent to a depression.

From contraryinvestor.com (highlight ours) ``So as we move forward in time and surely in continued Fed response to our current circumstances, we have a really hard time believing the entirety of the curve is about to drop meaningfully further in yield level. THAT'S the big issue here. And if indeed we're even close in terms of correct interpretation of the current structure of the curve and how that curve might act ahead, then low yields are already heavily discounted in total broader financial market values as we speak. It may very well be the Fed is truly pushing on the proverbial string if further Fed actions cannot stimulate meaningful alternative yield level response to the downside. We'll just have to see how it all works out from here. And God forbid the equity markets were ever to come to the pushing on a string conclusion.”

In other words, the heavily overbought bond markets is in a critical crossroad, again either we see some form of mean reversion where Treasury yields will spike (meaning higher rates ahead)- possibly impelled by a breakdown in the US dollar/US averts a recession and sees inflation spike- or the US economy succumbs to a deflationary recession.

Thanks to the contraryinvestor.com, the treasury yield curve will surely be in our watch list.