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Bond Owners Rejoice – the Fed Has Your Back

Most experts have been advising their clients to dump their U.S. Treasury bonds, which is the safety net for every portfolio, as the consensus view is that inflation is going to send interest rates higher and Treasury bond prices lower. Even though investors and experts do not understand how inflation occurs, it has not stopped the mainstream financial media from scaring people into dumping their bonds over the past two years while the “Smart Money” quietly buys them all up. The “Smart Money” always seems to be ahead of the game and the Fed’s latest move will lead to big profits for the “Smart Money” and those who own long-duration U.S. Treasury bonds.

When the Federal Reserve announced they were going to reduce and later stop the number of U.S. Treasury bonds they are selling, they also announced some other changes that would begin at the end of September when their balance sheet unwind is scheduled to stop. The Fed currently holds both short- and long-term bonds, in addition to Mortgage-Back Securities (MBS) or mortgage bonds. The Fed has decided they no longer wish to own long-term U.S. Treasury bonds or MBS, but instead maintain a balance sheet of short-term U.S. Treasury bonds.

To accomplish their goal, the Fed was planning to sell long-term U.S. Treasury bonds and MBS for short-term U.S. Treasury bonds starting in October 2019. At first glance, this might seem like a strange move, but with long-term Treasury yields falling, the Fed likely wants to lower short-term Treasury yields to keep short-term Treasury yields below long-term Treasury yields. The Fed seems to want to do this without having to lower the Federal Funds Rate, or overnight bank lending rate.

To understand the consequences of the Fed’s plan, it is important to understand what the effects of buying both short- and long-term bonds had on Treasury yields. When the Fed buys short-term U.S. Treasury bonds, short-term interest rates fall. When the Fed buys long-term U.S. Treasury bonds, long-term interest rates rise. This is why during Quantitative Easing 1-3 that short-term interest rates remained at zero percent while long-term interest rates rose.

Be aware, retail investors, most professional money managers, hedge-fund managers, analysts, and the financial media do not understand how the bond market works. In my research, there are less than five people in this country that seem to understand how the bond market works and some of them are dead. I realize that my views may seem counterintuitive, but they have been validated against the foremost experts in the field and so far, are correct.

The Fed decided to move forward with their plan to dump their long-term U.S. Treasury bond and MBS holdings starting last month instead of October without telling anyone. The likely motivation for the Fed is the fact that U.S. Treasury bond yields, with exception of 30-year yields, are all lower than the Federal Funds Rate. It is highly unusual for yields to be lower than the Federal Funds Rate, as such an occurrence usually foreshadows a recession. By buying short-term U.S. Treasury bonds the Fed is hoping to lower short-term interest rates, which should fall, but long-term yields are also going to continue falling.

When the Fed buys long-term U.S. Treasury bonds, long-term yields rise. As the Fed sells long-term U.S. Treasury bonds, long-term yields should fall, which means an investor who owns long-term U.S. Treasury bonds now has the Federal Reserve backstopping the value of their bonds. While the financial media will interpret the Fed’s move incorrectly, long-term Treasury yields should continue to fall.

When the Fed buys Mortgage-Backed Securities, volatility falls since large banks, who normally hold securitized pools of mortgages, must hedge their mortgage holdings against rising interest rates. As the Fed sells Mortgage-Backed Securities, volatility should rise. Rising volatility is interesting, since financial professionals, hedge-fund managers, and pension funds are all actively shorting volatility.

While investors have been dumping their bonds and selling volatility, the “Smart Money” has been buying U.S. Treasury bonds, buying volatility and taking speculative positions on both, as the “Smart Money” believes interest rates are going to fall and volatility is going to rise. When you understand the Fed’s latest move, the “Smart Money” starts to look brilliant, since the Fed is backstopping the value of long-term U.S. Treasury bonds.

When the “Smart Money” is buying securities, they have a target return in mind for their time. After all, most retail investors don’t have the patience to wait for one, two, three, or more years before realizing a return. Yet, the “Smart Money” makes their money very short periods of time, as they accumulate a position, make a positive return, then distribute their position. The longer the “Smart Money” accumulates a position, the bigger the return they are expecting.

When it comes to U.S. Treasury bonds, not only does the “Smart Money” plan on capitalizing on an increase in bond prices, but they receive a monthly dividend for their time while they wait. Looking back to 2011, when the “Smart Money” was buying bonds for the prior two years, bond prices rose eight percent in two months and continued to rise another three percent before the “Smart Money” got out. When factoring the two years to accumulate and the year to distribute all the bonds they bought, the “Smart Money” did well, especially when factoring the monthly dividend.

It almost seems like the “Smart Money” knows what is going to happen before it happens, as they seem to always be positioned on the right side of the market. In the case of their long U.S. Treasury bond position, the Fed is now selling long-term U.S. Treasury bonds which will cause yields to fall. Since most of the market participants are betting on the opposite happening, as yields fall, those opposing the “Smart Money” will eventually be forced into buying bonds.

Knowing the Fed is also trying to dump their Mortgage-Backed Securities and that those bonds cause volatility to rise, it suddenly makes sense as to why the “Smart Money” is buying volatility. While most investors do not understand volatility, think of it as a leveraged bet against stock prices falling. The further stock prices fall, the higher volatility goes.

When examining the Fed’s plan, it appears the “Smart Money” had the inside track to what is coming, and they have positioned themselves accordingly. Even when the “Smart Money” is wrong, which is not very often, they command such a large presence in the markets that they can make the markets move in the direction they want. Whenever possible, investors should seek to follow the “Smart Money.”

It is not terribly hard to follow the “Smart Money,” but it is not easy to execute an investment strategy around them. They have been manipulating the markets to their favor for over one hundred years, and they are good at it. The first place to start is the weekly Commitment of Traders (CoT) report, which shows how the “Smart Money” was positioned the week before.

While the CoT report should not be used as a timing tool, since it is deliberately delayed, it does lend insight into their positions. From there, an investor needs to analyze the charts to see if the two confirm each other. In this case, the CoT reports show the “Smart Money” is buying bonds and the chart pattern, which looks like a Wyckoff accumulation pattern, confirms they are buying bonds.

After analyzing the CoT data and the charts, an investor must determine the best point of entry and exit. While I never recommend that any investor trade volatility, since it is extremely risky, it is still not too late for those who do not own bonds. For those who prefer to own stocks over bonds, which is most American investors, the bond market is signaling that stock prices are going to head lower. The reason stock prices are headed lower is that stock price generally follows Treasury yields, which have been falling.

For those who do own bonds and are looking to buy stocks at a lower point, they are going to get that opportunity. The “Smart Money” would not be accumulating bonds and volatility if they were planning on losing money. Their position makes even more sense when the Fed is going to drive long-term interest rates lower and volatility higher due to the changes in their balance sheet unwinding program.

Where is this external shock to the financial system going to come from? After all, investors appear immune to Fed rate hikes, Fed balance sheet unwinds tariffs and trade wars. Look no further than the Eurozone banking system, where the fourth largest bank, Deutsche Bank, is about to explode. Their stock price is on its way to zero, as it currently trades for less than seven dollars per share.

The reason Deutsche Bank and other European banks are at such high risk for igniting a global economic meltdown is that their stock prices are following European bond yields, which are now negative, lower. It is normal for shares of bank stocks to follow government bond yields lower, which is why the price of U.S. bank stocks should be falling since Treasury yields are in a freefall.

The risk to Deutsche Bank is that it is holding $75 trillion worth of derivatives. For those who remember the mortgage crisis of 2008-09, the catalyst for the financial crisis was the implosion of bundled mortgage investments called Collateralized Debt Obligations. Derivatives are not exactly like CDOs, but they are equally as toxic. Should Deutsche Bank fail, there is not enough money in the world to rescue them. Should $75 trillion of derivatives start triggering, which would force investors to cover their positions, the global financial system would likely look like a star going supernova.

The risk to Deutsche Bank is very real, but they are not the only bank who is at risk of failure. There are five other large European banks whose stock prices are falling right alongside Deutsche Bank as the Eurozone falls into a recession. This is yet another reason the “Smart Money” is buying U.S. Treasury bonds and volatility since yields would crash and volatility would spike should European banks start failing.

In the meantime, investors need not worry if stock prices continue to rise since falling Treasury yields will eventually yank stock prices lower and cause volatility to spike. Once the cycle shifts and stock prices fall, the “Smart Money” will dump their bonds to buy stocks, which will be an opportune time for investors to take the risk. After buying bonds and volatility for the past two years, the “Smart Money” is looking for a big payday and so should you.

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