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Ban Bond Trading: Curve Inversions & The Reality Distortion Loop Of Reverse-Engineered Growth Slowdowns

"Why are you wearing that stupid trader suit?"

Trump needs to issue a market proclamation using his Muslim ban as a template.

Something like this:

I, Donald J. Trump am calling for a total and complete shutdown of bond trading in the United States until our country’s representatives can figure out what the hell is going on.

As you might have heard, folks are tying themselves in knots over the past 24 hours trying to “explain” or otherwise analyze multiple inversions in the Treasury curve. Specifically, the 3s5s and the 2s5s inverted on Monday and the market is abuzz with the obligatory “what does it mean, please tell me what it means!” hysteria.

Curve1

(Bloomberg)

3M10Y flattened by the most in years on Tuesday.

3m10y

(Bloomberg)

Ostensibly, “what it means” is that the market is worried about an economic downturn and I guess the key point here is that whether or not those worries are entirely justified is largely irrelevant past a certain juncture.

I imagine bond traders are going to hate this thought experiment, but at the end of the day, it’s entirely possible that the end-of-cycle trade is being pulled forward by traders themselves, who are looking at the curve and forgetting about their own role in shaping it.

Remember: there is no such thing as “the yield curve” outside of traders (carbon-based or otherwise). The bond market is something that exists because we made it up. Last time I checked, the Genesis creation story doesn’t have God creating the yield curve on any of his “working” days.

The point is, what you’re seeing when you look at the yield curve is you or else the actions of some algo you created to trade fixed income. If market participants aren’t capable of understanding that, then the potential exists for a self-feeding, reality distortion loop to take hold.

Nomura’s Charlie McElligott hinted at this on Tuesday morning, although he didn’t frame it quite like I just did.

“The ongoing collapse in UST yields along with concerns therein surrounding the nascent inversions in the front-end of the UST curve (3s5s, 2s5s, 2s5s swaps, 1m USD OIS 2Y-1Y fwd spread) have markets again ‘reverse-engineering’ a growth-scare”, he wrote, adding that “with [the] UST term premium again melting to lows last seen in September, the risk is that a negative feedback loop develops where the ongoing rally in USTs is viewed both as confirming a US slowdown and ‘pulls forward’ the already extraordinarily heightened market concerns surrounding the timing of a US recession.”

TP

(Bloomberg)

Again, McElligott doesn’t frame things with the same flair for the metaphysical as I did above, but conceptually, he’s saying the same thing.

If market participants “believe” what bonds are “saying” about the growth story without taking account of the fact that bonds’ “voice” is really just the “voice” of the people and machines trading them, well then the potential exists for everyone to get spooked and pull forward the end-of-cycle trade.

Of course the more concerned the market gets about the outlook for growth and inflation, the more traders will price out Fed hikes. Sure enough, EDZ9-0 is now increasingly pricing in a Fed cut in 2020.

EDZ90

(Bloomberg)

I’ll leave you with one last quote from McElligott that underscores how “perceptions” can become reality without anyone realizing what’s happened:

Between the above 1) “perception risk” surrounding the UST bull-flattening & inevitable curve inversions alongside 2) the impact of collapsing Crude and broad inflation expectations, the market is again at risk of the “we have already tightened ourselves into a slowdown” mentality gaining further foothold and bleeding sentiment, which can in-turn further realize “end-of-cycle” optics. 

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3 comments on “Ban Bond Trading: Curve Inversions & The Reality Distortion Loop Of Reverse-Engineered Growth Slowdowns

  1. Exactly ” At the end of the day, it’s possible that the end-of-cycle trade is being pulled forward by traders themselves, who are looking at the curve and forgetting about their own role in shaping it.” Expectations turn into reality, real machinery investment halts, projects are put on hold because commodities fall, etc. Unable to think one day with their heads, they shape their trades and views from what they read in blogs and twitter. Everything is magnified. Since months the curve is flattening, now it’s the buzz word in all social networks, all cats on all roofs talk about it. Ask them if they know what a bond rollover is, or a cheapest to deliver. Full with experts of the curve now. The same folk that was screaming inflation in October.

  2. In early October 2018 it was the 10 Year rising too fast that the media attributed to the stock market downturn. Now, the 10 year yield is falling too fast, the yield curve is inverting, and the media again points to the movement of the 10 year as an indicator of stock market unrest.

    Two different markets, with different investors, sending different signals.

    The Treasury bond market is dealing with too much supply on the front end, and not enough on the long-end – engineered by the US Treasury using the false assumption that lower long-term rates are better for stocks in an attempt to maintain the artificial stock market high created after Trump was elected.

    The stock market, plain and simple, is over valued.

    These two situations should not equate to an imminent economic recession; the market movements are a man made financial phenomenon that does not have much to do with the economy at the present time. However, if C-Suite executives panic and start to cut headcount as corporate interest costs go up because they have borrowed too much while doing stock buy-backs, and their personal stock option values tank in the process, there definitely will be a recession within 6-12 months.

    Pretty good odds that this scenario is about to happen; and it does not have anything to do with the trade dispute with China. It has everything to do with a failed worldwide central bank policy which has hyper-inflated stock values over the last 4 years and caused poor allocation of capital in the financial system worldwide. You can thank the ECB, BOJ, PBoC and the Fed.

  3. There is still a huge short bet in the 10 year, maybe there is a squeeze?

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