Look for a big rally on Friday, after Bernanke practically tells the market he's going to cut rates on Sept. 18. That should bring long-term debt vehicles and short-term debt vehicles back in line with each other again. Here's why it'll happen:
There's lots of worry over short-term debt right now. That's reflected by the 13-Week Interest Rate (IRX) index, the shortest term yield vehicle we can get implied volatility (IV) from. On a 10-day basis, IRX is 144% -- let's say four standard deviations -- above its mean. It's even worse than that, though, because IRX IV has soared to the unheard-of level of 44. So short-term yields are rising crazily, meaning short-term bonds are falling.
The longest term yield vehicle we follow -- 30-Yr. Interest Rate (TYX) -- is going the other way. On a 10-day basis, TYX is 79% below its mean. TYX is about the same on a 90-day basis, more than two standard deviations below it mean. So long-term yields are heading down, which means long-term bonds are rising.
Those short-term yields are out-of-whack. Nothing you can trade, because the point movements are so slight due to single-digit IVs. But these are serious spreads that are going to attract the Fed's attention.
The Fed's goal will be to preserve the value in the short-term paper that investment banks are holding. Once we get past the next two or three months, this asset-backed paper will have expired. And it isn't coming back for a while. That's why the longer term bonds are stronger. The Fed will deal with replacing that short-term debt next next year. First things first.
With the downgrades today from Merrill Lynch, this could be a nice upside trading opportunity for the broker/dealers. Broker/Dealer (XBD), after a tepid rally, is slightly better than two standard deviations below its mean on a 90-day basis. The index will rocket back up above 90-day neutral if the Fed says it will cut. We'll short the index again in Zone 6.
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