Posted By thestatedtruth.com on September 1, 2010

Front Running the Fed

September 1, 2010

“… the public is no longer investing in stocks, but rather in bonds.  So far this year through July, bond mutual funds have attracted $224.4bn in net inflows including reinvested dividends.  Equity funds have attracted only $17.2bn ytd, with $32.2bn going into International funds while $15.0bn flowed out of Domestic funds.” — Ed Yardeni, September 1, 2010.

Understanding the movement of markets (prices) requires the examination of flows of funds.  Stocks in America have experienced malaise, while bonds have been on an upward trend in prices (falling yields).  The mutual-fund flows cited above demonstrate why this is so.

Add to this the actions of the Federal Reserve this year, and a fuller explanation of the bond markets becomes apparent.  The Fed terminated the purchases of $1.25 trillion in GSE mortgages and mortgage-related paper in March.  It was fully transparent in its strategy, as it should be.  Simultaneously, the housing-purchases credit subsidy ceased.  Housing went into relapse, as most economists expected.  Simply put, subsidize something and you get more of it; remove the subsidy and you find that you have borrowed economic activity from the future, and now you get less of it.  That is the condition of the housing market.

The federal government has made a decade-long mess of housing finance.  Fannie and Freddie are fully discredited.  They are costing the US taxpayer mountains of billions due to the losses.  The US Treasury effectively guarantees their debt.

The Fed now faces the issue of watching its mortgage holdings prepay at speeds that are difficult to forecast.  We wrote about this on Monday.  See “The Emperor, the Gladiator & the Lion” on our website, www.cumber.com.  In that commentary we noted how the world is trying to front-run the Fed.  We offered that the “rest of the world is watching, trading, investing, swapping, hedging, and attempting to front-run the Fed’s tsunami every single minute.”

Many readers commented on this issue of front-running the Fed.  We thank them for their email.  Some asked for solid evidence.  We can draw inferences form market movements.  We can ask investors and institutional traders and acquire anecdotes.  We can observe our own trading behavior.  We can survey sentiment and receive interpretations of the survey data.  However, we cannot definitively prove that the there is front-running.  Such a proof is impossible.

Logic suggests to us that some of this behavior exists.  It is a human instinct to try to get in front of the crowd.  Therefore, our conclusion is that part of the upward movement in Treasury-bill, note, and bond prices (falling yields) is due to investors positioning themselves ahead of the Fed as the Fed rebalances its asset holdings from mortgage paper to Treasuries.

We expect this behavior in the markets to continue, since the Fed is going to pursue this transition for the next year, and since the amount involved is nearly half a trillion dollars in purchases of treasury securities as the mortgage paper runs off.  When the world’s largest buyer of US treasury paper is transparent about its intent, it is better to be in front of this 800-pound gorilla than behind it.  Note that markets have a forward-looking expectations component.  Market agents will anticipate the ending of the Fed’s purchases before it actually occurs.

We thank our readers for their supportive comments.  We particularly thank Art Cashin, who offered an alternate punch line to the gladiator joke.

We are scheduled to talk about markets on CNBC at 10 AM today

Then to Maine and the Labor Day weekend at Leen’s Lodge.  Hurricane Earl: you are not invited.

David R. Kotok, Chairman and Chief Investment Officer

Copyright 2010, Cumberland Advisors. All rights reserved.

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Cumberland Advisors supervises about $1.4 billion in separate account assets for individuals, institutions, retirement plans, government entities, and cash-management portfolios. Cumberland manages portfolios for clients in 43 states, the District of Columbia and in countries outside the U.S. Cumberland Advisors is an SEC registered investment adviser. For further information about Cumberland Advisors, please visit our website at www.cumber.com.

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