Front-end rate trade

Posted By Darren Winters on Nov 27, 2018

Front-end rate trade

At some point, traders/investors are going be jammin to a new tune, the front-end rate trade.

The front-end trade is guestimating when the Fed, the world’s central bank by default eventual blinks, pauses or even walks back its normalization policy

Since October’s sell-off in stocks, the bears are finally feasting with many stocks now falling into bear territory. Bear markets provide short sellers with a moveable feast. Short sellers profit from the lower highs and lower lows that characterized a cyclical bear market.

But the front-end rate trade, the three move ahead play anticipates a Fed pauses or U-turn in its normalization policy.

The pot of honey gets snatched from the bears when the front-end rate trade becomes the next profitable play

Front-end rate tradeThe stock market is the Fed’s trillion dollar yoyo. Put another way it is a pseudo stock market because it is the Fed’s liquidity rather than the price discovery mechanism that determines stock prices today.

The front-end rate trade strategy factors into the equation a U-turn in Fed monetary policy.

So in the last decade, we witnessed the greatest monetary easing experiment in the history of finance. The Fed and its western aligned sidekicks, ECB, BoE, BoJ flooded the financial system with trillions of dollars of liquidity through a bond purchasing program known as quantitative easing (QE) and near zero rate interest policy (ZIRP) to keep assets prices propped up.

The central bank’s monetary accommodation (also known as emergency monetary policy) fuelled the longest bull market in stocks (and practically all assets) which created the bubble of bubbles.

Moreover, the divergence between the underlying economy and the QE bull rally in stocks continued.

Sovereign debt default in the periphery countries of the EU or Deutsche Bank’s credit downgrading and rising risk of a default where all potentially systemic risks. But they didn’t halt the bull market.

It was as if the more diabolical, hopeless the situation seemed the more the bulls just kept running.

This negative divergence (theoretically a bearish signal for stocks) between hard data and the bull market continued. But “In a mad world, only the mad are sane,” Akira Kurosawa.

So the front-end rate trade strategy is based on a whacky scenario where bad news is good news

Let me explain by using the“insane rule, it is a short and simple formula with just three variables. A (pending financial crisis ), B (central bank intervention) and C (markets will go up)

Now, the rule states A=B and B=C, so A=C.

Therefore, applying the rule to contemporary markets a financial crisis means markets will go up, put another way bad news is good news under this warped logic.

So applying the “insane rule” any potential systemic risk whether it be an Italian debt default, GE bond downgrading to junk status all equals stocks will rally.

The front-end rate trade strategy is about front-loading the central bank’s next move

But knowing when central bank intervention, variable B, will kick in is the tricky part of gaming the game.

Our 50 cents worth is that the Fed will blink, in other words, halt their policy of “monetary normalization” or even reverse it when the monetary system appears to be at risk and about to keel over.

In other words, the front-end rate trade strategy could yields profits if we can determine what market event is considered to be a systemic risk that could collapse the entire monetary system. At that point, the Fed would come to the rescue with QE to infinity.
Now let’s take apart the monetary system. The Fed, a private for-profit corporation with secret shareholders owns the world’s hottest brand, the USD, the world’s reserve currency.

USD is a fiat currency based on debt. High up the food chain investment banks pledge Prime sovereign bonds, blue-chip corporate bonds (like GE) as collateral to raise loans amongst each other. So debt (bonds) equals money, moreover, when prime debt gets downgraded to junk, it becomes a systemic risk because it threatens the stability of the fiat debt monetary system.

For traders/investors post-2008 financial crisis was about gaming the front end rate trade

The collapse in mortgage-backed securities (debt) created a systemic riskand the Fed was forced to intervene with QE, unprecedented amounts of liquidity and ZIRP to save (their) system.

What is likely to make front-end rate trade a profitable play in 2018 and beyond

If the corporate credit market looks problematic then the probability of Fed intervention is likely to be high. The Fed is likely to blink when there is a downgrading of prime corporate debt to junk status. Such a market event would be perceived by the Fed as a systemic risk.

Note that it was not the US President Trump calling the Fed “crazy” over rate hikes that got the Fed to reconsider its normalization policy but rather the credit downgrading of GE bonds to near junk bond status. So a Fed pause potential could be on the cards.
Here is the takeaway from the front end rate trade; the downgrading of corporate debt could gain momentum in a rising yield environment. At some point that is likely to force the Fed’s hand to either halt or make a monetary policy U-turn. Being on the wrong side of the Fed’s liquidity cannon is a losing hand which has been a painful lesson for the bears in 2009.

The front end rate trade or the Fed Chair Powel put (where the Fed injects liquidity into the market to encourage risk-taking) could be the next tune in 2019. So it could be that we’re jammin to QE infinity and it is back to BTFD trading?

Over to you.

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