What the “Smart Money” Knew

It almost appears the “Smart Money”, who are high-level corporate insiders, institutional investors, and other well-connected investors, can predict the future when looking back on how they were positioned ahead of major events in years past. While it appears the “Smart Money” is psychic, investors need to understand it is the markets that make the news, not the news that makes the markets.

Even though the “Smart Money” began accumulating positions in Treasury bonds as early as 2017, it is merely coincidental that some of the recent news is highly favorable to their positioning. There are a few things the “Smart Money” knew and their timing has more to do with their patience than foresight of events they could not even possibly predict.

The “Smart Money” has advance knowledge of changes to monetary policy since the large commercial banks are in regular communication with the Federal Reserve. Final decisions on monetary policy are not known until they are announced, however, the large commercial banks have a strong idea of the direction in monetary policy.

Knowing the direction the Fed is likely to take monetary policy helps the “Smart Money” know how to invest for the maximum potential gain. When the Fed begins a monetary easing cycle, which they did by lowering the Federal Funds Rate back in mid-2018, interest rates are soon to fall. In October 2018, Treasury yields peaked, and bonds began to outperform.

Back in 2017, buying bonds would have not made much sense as most investors were selling their bonds to buy stocks in hopes the global economy was on the cusp of another massive reflation cycle. While most investors were selling bonds, the “Smart Money” continued to buy until the supply of bonds was low. As bond prices started to rise and gain momentum, quantitative computer models began buying bonds.

By October 2019, the formulas for the quantitative computer models dictated it was time to unload their Treasury bond positions since momentum was shifting. It was entirely coincidental that the trade war would end in two months, which most investors believed would be very inflationary. Treasury yields and interest rates began to rise ahead of the trade deal, even though the computer models were not trading based on the news, but on momentum-based formulas.

Over the next four months, as the quantitative computer models sold, investors and speculators piled in on the trend in hopes the rise in Treasury yields was the market suggesting inflation was finally coming. As it turns out, the “Smart Money” was not done accumulating Treasury bonds as they bought up the remaining supply of bonds.

In January the world would start to learn about the Coronavirus, which has the potential to greatly reduce the already low rate of global economic growth. The Coronavirus could tip the already wobbling domino that sends the global economy into a recession. As the Coronavirus spread, bond prices began to rise. The timing of the recent rally in bond prices and the Coronavirus is merely coincidental.

The news is interpreting the late-January rally in bonds to mean the market is concerned about the Coronavirus. It is highly likely the rally in bond prices would have happened anyway since the “Smart Money” has spent the better part of three years buying as many bonds as they can. Had the Coronavirus never existed, the news would find another reason to explain the sudden risk-off message the bond market is sending.

While it appears the “Smart Money” knew some of these events were going to occur, it was impossible for them to know. The news is constantly trying to assign reasons why the stock market rises or falls on a daily basis. Yet, based on the “Smart Money” buying bonds over the past three years, it appears there is a much larger force driving the bond market than the recent news events.

The “Smart Money” knows when the Fed starts to ease monetary policy after a long tightening cycle, its easing will actually further tighten monetary policy. Monetary policy does not start easing until interest rates fall well below the floor set during the prior easing cycle. Any attempt to ease monetary policy while interest rates are above the floor set during the prior cycle will lead to tighter financial conditions. When financial conditions tighten, it leads to lower long-term Treasury yields.

When the Fed started purchasing Treasury Bills in October 2019, it was a signal to the “Smart Money” to load up on as many Treasury securities they could before Treasury yields collapsed under the weight of the Fed trying to ease monetary policy. Buying Treasury securities became even more attractive to the “Smart Money” when the Fed indicated they would run out of Treasury Bills in a few months and be forced into buying Treasury Notes.

As the Fed gobbles up the supply of Treasury Bills and starts buying Treasury Notes, it forces investors, pension funds, institutional money managers and large commercial banks who might normally buy shorter-term Treasury securities, to buy longer-term Treasury securities due to the lack of supply. Compared to Treasury Bills, the supply of Treasury Notes and Bonds is smaller, which leads to lower long-term Treasury yields as investment dollars chase a small supply of bonds.

The Fed was not the only buyer of Treasuries since trend-following computer models were also buying bonds in 2018. The “Smart Money” knew the trend-following models would sell if momentum shifted lower, which it did in October 2019. Over the next four months, the trend following models dumped a large portion of their Treasury bonds while the “Smart Money” eagerly bought them.

When debt-based economies run out of steam, they experience a deflationary shock that can only be cured by central banks lowering interest rates. When interest rates fall, bond prices rise, and the further interest rates fall, the higher bond prices go. When looking at a regression channel, or two parallel lines drawn along the top and bottom of a trend, of ten-year Treasury yields, it suggests ten-year Treasury yields are likely to go negative during the next recession.

Should ten-year Treasury yields go negative, which further suggests thirty-year Treasury yields will fall to one percent or less, long-term Treasury bond prices will rise approximately thirty percent. It also implies thirty-year zero-coupon bonds will rise as much as fifty percent. The “Smart Money knows interest rates and Treasury yields need to fall to reignite the economy, and Treasury bonds are the fastest way to profit when the floor falls out of the economy.

The “Smart Money” wants to accumulate as many bonds as they possibly can to profit on the largely expected move in bond prices. In addition the trend following models, most computer traded models, which represent approximately eighty percent of all trading on the exchanges today, are heavily allocated to stocks with very low or no allocation to bonds. When this mountain of money shifts from risk assets to safe assets, it will send bond prices skyrocketing just as it has on the onset of prior recessions.

While the “Smart Money” has a deep understanding of the monetary system and deflationary shocks that come with recessions, they also understand the yield curve. The yield curve is the difference between short-term and long-term interest rates. In a normally functioning economy, long-term interest rates are higher than short-term interest rates. When long-term interest rates fall below short-term interest rates, it is an indication monetary policy is too tight.

The problem with an inverted yield curve, when long-term rates are higher than short-term rates, is banks borrow at short-term rates to lend at long-term rates. When the yield curve inverts, banks tighten lending standards to reduce lending demand. As lending growth slows or stalls out in a debt-based economy, it leads to a recession where the central bankers are forced into lowering interest rates.

As of the time of writing, five-year Treasury yields and below are all less than the lower bound of the Federal Funds Rate, which is 1.5%. Ten- and seven-year Treasury yields, which were nearly inverted a week ago, are both below the upper bound of the Federal Funds Rate, which is 1.75%. By buying bonds, the “Smart Money” is causing Treasury yields to fall to force the Fed into cutting the Federal Funds Rate. When the Fed cuts rates, either directly by lowering the Federal Funds Rate or indirectly through Quantitative Easing, Treasury yields fall and Treasury bond prices rise.

The “Smart Money” knows they can manipulate the Fed into cutting interest rates so they can profit by selling their huge cache of bonds to retail investors and to many computer models who have little to no bonds in their allocation. Retail investors and the computer models will be desperate to own bonds since Bull markets in Treasury bonds coincide with crashing stock prices. Since most investors and computer models currently do not have very much downside protection, the “Smart Money” also knows who they will sell their bonds to for a fat profit.

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