Widowmaker Trade Setup: QE taper begins = Godzilla Bond Rally

Regular readers know how I consider trading the bond market in todays environment. I use the cash for clunkers bond trading model, where QE pulls forward sales of bonds which artificially depresses bond prices. Then when QE ends, there is a vaacuum of buyers, which then causes a huge rally in bond prices.

Today is the day when the fed is expected to announce the taper. So, we are probably very close to a bottom in bond prices.

This very basic premise has worked extremely well during the prior rounds of QE. It’s pegged the bottom of bond prices within a few days over the last 5 years.

Today is the start of the taper of the recent round of QE. This means it’s probably time to get long bonds again if you are the type of person who trades bonds.

This is what the widowmaker trade looks like in real time. In real time, there is usually a huge number of reasons to think “ah, we’ve finally solved the problem, and inflation is just around the corner.” In real time, it seems like bonds cannot maintain these low yields for any longer.

Yet the structural problems remain in place and dominate any other factors. We are still near top valuations in the real estate market. This is a natural barrier to economic activity. We still have a large amount of unemployment which keeps a lid on prices. We still have a large amount of spare capacity, which keeps a lid on prices. Commodity prices have not translated into much economy wide inflation, so there is no reason to think it would happen now.

In real time, it feels like the bad times are over. But it’s not over, so there is are strong reasons for yields to remain low.

Recent inflation numbers are very low.

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.1 percent in August on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, the all items index increased 1.5 percent before seasonal adjustment.”

All of this points to a repeat of what happened in the bond market during the prior rounds of QE. Here is an updated chart, showing the current rally in bond yields.

It’s easy to envision tapering causing bond yields to hit new lows. The path to the new lows might be a bit slower than what happened after QE I and II because a taper is different than just ending purchases. I expect this bottom in bond prices to be less defined then the prior bottoms due to the difference between tapering and ending.

But still, it’s time to start seriously considering being long U.S. government bonds.

 

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Erik V
3 years 6 months ago

I think with the yield curve being so steep, a FF rate hike probably 3+ years away, low inflation, and weakening job growth, we will probably get a rally in bonds soon. Interesting that the taper has been delayed and bonds are rallying this afternoon. It’s just really hard to believe the yield curve can maintain this level of steepness for a significant amount of time with a FF hike so far away.

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