Trader’s Narrative

Going back to the end of November 2007, the bond market was giving a great signal that a rally in the equity markets was about to unfold. From the time I wrote about it to its top in December 2007, the S&P 500 Index gained 100 points (1410 to 1510). That may not seem like much in today’s topsy turvy market. But you have to remember that back then the VIX was at ~20.

The idea is that the rate of change in the bond market has a bearing on the equity market. I first read about this in Mark Boucher’s book, The Hedge Fund Edge where he outlines dozens of similar ideas.

Put simply you buy when the rate of change in the 30 year bond yield is less than or equal to 9% and sell when it is above that level. The performance for this simply system is impressive. Equally impressive is that doing the opposite isn’t profitable. This is a sign that we aren’t data mining but dealing with an inherent relationship in the financial markets.

I use a variation of this system, however, the most recent signal didn’t work and I suspect it had to do with the craziness that we’ve seen in all financial markets:

Today we’ll be keying off only one market tell: the scheduled Federal Reserve rate cut decision.

I’ve been following a simple model of the Fed’s actions: approximation of the 90 day US government T-Bond yield. At yesterday’s close, the 3 month US Treasury Bond’s yield was 2.280% and in overnight trading they were a bit lower at 2.20% (last time I checked).

Here’s a recent graph comparing it with the Fed rate (in blue):

If only they’d listened to me when I suggested they cut, way back in the summer of 2007!

The Fed is now way behind the curve and in a desperate (some say futile), last ditch effort to forestall a recession in the US economy. I know this sounds crazy but they would have to cut 125 basis points to bring the Fed target rate in line with the bond market - see above graph.

The odds are that we will get a generous rate cut. But probably not that generous. According to Federal Fund futures, we have more than a 70% chance of a 50 basis point cut and about a 30% chance of a quarter point cut. But really, no one knows what the Fed will decide.

All I know is at 2:14 pm today, the futures will go nuts. Since the market is clearly expecting (and needs atleast) a 50 basis point cut, anything less will be a major disappointment. If we get anything more, we could be riding a rocket. The market is clearly in a very oversold condition and a catalyst like an unexpectedly larger rate cut would be all it needs to recover. If we do get exactly 50 basis points, we could flail around and end the day unchanged for the most part.

In any case, the first directional jab is usually a head fake, or has been in the past. So unless you really really have to don’t trade around the decision time.

If you do, just know the risks. Including the risk of losing internet connectivity, losing power, etc. Believe me, you don’t want to be stuck in a position that can move against you mercilessly unless you have planned for every contingency.