Fed and Yields Headed Down

by Alex Roslin
SeekingAlpha.com
November 21, 2007
[original story]

As the markets zigzag crazily up and down, all eyes are on the Fed. Will it or won’t it? That is: will it keep cutting interest rates and reignite the equity bull and reflation trades? Fed officials are suggesting that’s unlikely, which is worrying the markets.

But some little-noticed data from another federal agency tells a much different story. The Commitments of Traders reports, issued free each week by the Commodity Futures Trading Commission, are uniformly bullish for Treasuries, suggesting interest rates will keep falling.

In fact, much of the data is at bullish extremes not seen in years across the entire yield curve—from the 30-day Fed Funds contract out to the 30-year Treasury Bond. (When traders get bullish on bonds, it means they’re betting interest rates will fall. That’s because bond prices trade opposite to yields.)

In early November, the “smart money” large speculator funds in the 30-year bond flipped from a net short to a super-bullish net long position as a percentage of the total open interest for the first time since Feb. 2006. (The bond is tradable with iShares Lehman 20+ Year Treasury (TLT) or the SPDR Lehman Long Term Treasury (TLO).) Normally, the large specs are seen as the “dumb money” in most markets, but my research has found there’s an important exception to this rule—the Treasuries. Here, these guys—the big investment firms and hedge funds—tend to be positioned correctly.

So what is the dumb money in the Treasuries—the commercial traders—doing right now? They’re super-gloomy. Turns out they haven’t been this bearish on the 30-year bond since early 2005. Since the commercial traders are usually wrong when it comes to guessing the direction of Treasury yields, this is actually a bullish sign for the bond.

Last Friday’s data has given me my fourth consecutive bullish signal in my trading setup for the 30-year Treasury bond based on the COTs data (meaning traders are betting the yield will fall). This setup first flipped to a bullish signal with the Aug. 21 COTs report.

Also long are my setups for the 10-year Treasury (tradable with iShares Lehman 7-10 Year Treasury (IEF) and SPDR Lehman Intermediate Term Treasury (ITE)) and five-year Treasury (tradable with iShares Lehman 3-7 year Treasury Bond (IEI)). They flipped to bullish with the July 31 COTs report, amid last summer’s subprime crack-up.

As for the short end of the yield curve, the data is even more bullish. In fact, the COTs data for the 3-month Eurodollar contract (which I’ve used to develop a signal for the 13-week Treasury Bill) hasn’t been this bullish since way back in July 2003. Remember those scary days? That was precisely the bottom for the T-Bill yield, as it hit below the amazingly low level of 0.8 percent amid the post-dot-com deflation panic and Iraq war. (The T-Bill is tradable with SPDR Lehman 1-3 Month T-Bill (BIL) or iShares Lehman Short Term Treasury Bond (SHV).)

Back then was also the last time the "smart money" small traders in the 3-month Eurodollar contract had a net position above zero as a percentage of the total open interest. They were net short all these years until they went back to net long in October. My trading setup for the T-Bill trades on the same side as the small traders in Eurodollar futures and options. They've been on a bullish signal since Feb. 2007 (meaning they're betting the T-Bill yield will fall).

And what about the 30-day Fed Funds contract? Here, the data is also super-bullish. My setup, based on trading on the same side as the large speculators (the traders with the best record for the Fed Funds), flipped to bullish with the Sept. 25 COTs report, thus ending a two-year bearish signal. (The Fed Funds contract is also tradable with BIL.)

So what’s the upshot of all this? Firstly, the COTs data suggests Fed chief Ben Bernanke may soon be confronted with strong pressure to lower rates. Secondly, the numbers are generally bullish for equities, but they also could be signaling reduced inflation and even a serious preoccupation with looming economic dislocation. That, ultimately, may not be so bullish in the longer run after all.