The Bond Market’s Negative Reception of QE3 and What It Means

Yields rallied after QE3 was announced. The 10-year note yield jumped and made an exact test of its 200-day moving average at 1.84%, just two basis points below medium-term resistance at 1.86%. After some wild swings the yield closed unchanged. The general media perception that the rally in bonds was caused by portfolio managers reallocating funds to riskier assets is not entirely correct.

This view may even be wrong according to some who think that bonds are becoming risky assets because QE3 will cause inflation to rise. We have seen commodity and energy prices rising when talk of QE3 started. The dollar plunged at the same time. These trends have the potential of causing inflation, or even worse, stagflation. Bond market participants may be thinking that although QE3 promises lower yields, suddenly yields may start to rise because of inflation and they are reducing portfolio duration by selling notes and bonds.

This is what bothers me: if the FED program is to be successful, yields should drop. This means that stocks should drop and the dollar will rise given the longer-term correlations that are in effect. Will the FED make sure that it is not ridiculed by causing the rates rising? Is the FED caught between a rock and a hard place here? But wait! Maybe an intervention in favor of the dollar will help to reverse trends in FED’s way. We’ll see…

Two things to notice from the daily chart of the 10-yr note yield above. (1) Yesterday yields rallied and exactly tested the 200-day moving average at 1.84%. (2) Yields made a high yesterday just two basis points below resistance at 1.86% and if that breaks and becomes support, then we may be talking about a closure of the gap left behind in April of this year at 2.05% and above, meaning we may have a substantial rally with a corresponding drop in bond prices (Bond yields move opposite to price in a way that is governed by an exact mathematical relationship).

But as I wrote yesterday, there are other potential factors that could cause bond yields to rise and some may be unknown (except to savvy bond market participants).

Disclosure: no relevant position at the time of this post.

Charting program: Amibroker (Charts created with AmiBroker – advanced charting and technical analysis software. http://www.amibroker.com/”)

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