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ChartBrief 146 - Bond market sentiment pre-Fed meeting


The September FOMC meeting starts on Tuesday next week. Odds are good that they either announce QT (Quantitative Tightening) or flag its impending arrival. As I previously outlined, there is an increasing case for the Fed to implement its previously announced plans for passive QT - aka balance sheet normalization, which would entail the phasing out of reinvestment of proceeds from maturing debt holdings. The current practice of reinvestment maintains a basically steady level of bond holdings, while allowing the bonds to simply mature would result in a steady run down of the Feds substantial balance sheet; built up through successive quantitative easing programs.

The big question is how markets will react. The announcement of balance sheet normalization plans means it should be on people's radar, but there is a very real prospect of a bond market QT-Tantrum. At present, bond market implied volatility has turned up from a record low - showing still a relatively calm and complacent market. Meanwhile, speculative futures positioning shows the hedge funds are still extremely net long bonds - and the crowd is usually wrong at extremes. Basically these are the types of conditions that makes a market particularly vulnerable to a big move, and the September FOMC meeting will provide probably the best near term catalyst to trigger crash in bonds and a spike in bond yields.

It's entirely possible that the Fed opts to do one-up on the Bank of Canada, which just last week hiked interest rates a second time, but my view is the Fed wants to get on with balance sheet normalization, and is in no hurry on interest rate hikes (yet). So expect the Fed to announce passive QT, and watch out for the reaction from a complacent bond market...

Bond market volatility looks to have bottomed after reaching a record low - notably it also reached record lows just prior to the taper tantrum; an ominous and fitting comparison given the Fed meeting next week.

Speculative futures positioning went from extreme, crowded, shorts at the start of the year, to now crowded longs - so will the hedgefunds get caught off-guard again? The crowd is usually wrong at extremes...

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