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As expected, the Fed’s ‘extended’ easy money meant trends ‘extended’ as well, as even govvies rallied in the face of an extension of the up trend in equities. And as far as the govvies go, this has happened before, and there is even more reason to allow that they can rally along with equities this time. This has been part classic govvies ‘hostage to fortune’ rally (i.e. anticipation of equities stalling out into a downside correction) and part yield curve comfort now that the FOMC and Mr. Bernanke have signaled no risk of a rate hike for at least four months.
While that doesn’t make the govvies a bull market, it allows for near-term buoyancy. But it comes with a lot of risk. In a nutshell, we see attempts to monetize the annualized yield spread between Federal Funds and the 10-year T-note as a fool’s game. Accepting a 75 basis point nominal profit per quarter for holding longer dated govvies is pretty reckless. That’s on two fronts. In the first instance, the major bullish cycle in govvies which proved so tenacious and more robust than most people might’ve imagined across many years has very likely reversed into a major bearish part of the cycle.
Those owning the ‘flattening’ trade (i.e. long the long-end on short-money borrowing) are risking that the primary trend might hit them at any time; even if there is zero chance for a Fed rate hike. Let’s face it, if any strong equities activity should foment near term weakness in govvies, an immediate loss of quite a bit more than potential earnings on the trade for a full quarter could occur at any time.
That said, there is nothing wrong with owning a bear market for a limited potential, as long as that is also for a limited amount of time. Yet, any profits in this case are more likely to be related to the equities and govvies returning to more classical counter-trend activity from their recent mutual rally. And there are good reasons that is likely to occur fairly soon; either for better or worse in each asset class.