An example of what can really drive the markets

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John Forman - The Essentials of Trading author

Yesterday was a pretty interesting day in the markets. And I do mean “markets”. Most people will probably be aware of the large decline in stocks. Fewer folks are aware of what happened in the fixed income (interest rate) market. Actually, that’s where the real action was. The Dow lost nearly 200 points, but that’s not nearly as dramatic as it sounds, even when you add in the two down days prior it’s not that big a deal. We’re just so used to low volatility that it seams like a lot. In days gone by, that kind of action was much more commonplace - up and down.

The bigger volatility was in interest rates. The 10 Year Treasury Note yield jump 16 basis points (1 basis point being 1/100th of a percentage point or 0.01). That is a substantial one-day move! Actually, early this morning it was up another 12 basis points from yesterday’s afternoon’s levels, though as of this writing it’s since come back down some. This is the real story.

There’s been a kind of capitulation. For reasons only they know, some major players in the market were of the view that the Fed was going to cut rates this year. In the last few days, though, thanks to some good economic data, they’ve finally dropped those expectations. To top it all off, Bill Gross who runs PIMCO, the world’s largest fixed income fund management company actually publicly turned bearish on the US fixed income markets yesterday (meaning he sees higher rates ahead). That helped to push rates across the board higher.

Here’s the interesting part, though. Guys I work with who cover different facets of the rate market described to me a scenario in the mortgage market that was very similar to that which took place back in 1987. Those who recall that time period might be aware that so-called portfolio insurance was one of the major causes for the sharpness of the Black Monday violence. In essense, portfolio insurance was a strategy by which portfolio managers hedged their portolios by selling futures short in a kind of delta hedge. The problem was that as the market went down the managers were forced to sell more and more futures to maintain their hedges, creating a kind of cycle.

Something similar was going on in the mortgage market yesterday. Hedging strategies there were causing the same kind of cycle to take place. As rates rose (prices fell), portfolio managers were forced to sell to keep their hedges in order, push rates higher still, causing more hedge selling.

Naturally, the rapid rise in interest rates spooked the equity markets.

These are the sorts of situations regulators and institutional market participants fear. It was just this sort of thing that cause the downfall of Long Term Capital Management (LTCM) and some folks have their eyes open to see what funds or investment banks might have taken a major blow to their capital thanks to recent events - something from which they might not be able to recover and which could have a carryover impact on the markets.

Something to think about.

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Here are some other posts which might interest you:

Fixed Income and Stock Trading
Interest Rates and PE Ratios
How Can Interest Rates Go Below Inflation?
Understanding the Fixed Income (Interest Rate) Market
Assessing Your Trading Expectations for Your Trading Plan