The Rude Awakening
Wall Street, New York
Wednesday, October 18, 2006

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• Find out what the smart money is doing these days
  when it comes to bonds,
  
  
• A graph incredible enough to wow your senior editor,
  
  
• Flying south for the winter, treasure hunting on Wall
  St. all the market data and plenty more...

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One step closer to the sandy little stretch of coastline he
calls home, Joel Bowman reports...

Trying to find - and join - a cricket match on Christmas
Day in New York City would be a lofty task for even the
most resourceful cricket enthusiast. But for a part-time
Aussie batsman with an unmentionably poor average, it would
be next to impossible.
 
Trying to find surfable waves anywhere in the vicinity of
Central Park would also present a considerable challenge.
For these and other reasons, your antipodean editor has
decided to fly south for the winter.

"So you finally booked 'em!" gushed a particularly
sentimental mother when we placed a late night phone call
to deliver the news of our planned trans-Pacific journey.

"We were beginning to think you were going to miss the
match, mate," chimed in the opposing team's star batsman –
also the father of your editor. "There'll be plenty of
waves as a consolation after we give your team another
thrashing like last year," he didn't forget to add.

"About that surf," we started, thinking of a way to steer
the conversation away from the memories of last season's
painful cricket losses, "I was thinking of ordering a new
surfboard for the occasion. It might come in handy if there
is ever any downtime in the Laguna Beach office when I
return."

"Well, you better start saving those U.S. dollars of
yours...25 year-old editors are not in Santa's purview,
last time we checked." The connection was a little poor at
this point, so this could have come from either parent.

It is a good thing we have been saving our beer money in
preparation for this very purchase. So, just how many
dollars can a parched Aussie stuff away with nearly two
months of sobriety under his ever-loosening belt? Probably
enough for a used surfboard...but not nearly enough to buy
even a single $1,000 Treasury bond.
 
No worries, if Eric's observations about the Treasury bond
market are correct, the surfboard will be a much better
investment...

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Bonds Away!
By Eric J. Fry

"Oh wow! That's incredible!" we gasped to ourselves when we
first observed the squiggles on the chart below. Squiggles
on a graph rarely elicit an "Oh wow!" from your even-
tempered California editor. Typically, he reserves his "Oh
wows!" for animate, three-dimensional phenomena. But in
this particular case, he simply could not stifle his
amazement.

"Why are the commercial bond traders SO short the bond
market?" He wondered to himself. "Why are they are holding
their largest net short position – by far – of the last
twenty years?"

The short answer is that we simply don't know. We do not
know why the "Commercials" are so short; we only know that
this situation is VERY unusual and, at the margin, NOT
bullish for 10-year Treasury notes. The commercial futures
traders, as we have noted several times in this column,
tend to position themselves correctly in advance of major
turning points. In other words, they tend to "buy big" just
before major rallies and "sell big" just before major
corrections.

These "smart money" guys aren't ALWAYS so smart, of course.
They often find themselves on the wrong side of a trade for
a long time. But whenever the Commercials hold extremely
large long or short positions on a specific commodity
future, investors ignore this fact to their peril.

During the summer months, for example, the Commercials had
amassed very large net-long positions in wheat and very
large net-short positions in crude oil. Shortly thereafter,
wheat soared and crude oil tanked. As noted, the
Commercials aren't always so smart. But neither are they
often very stupid...which brings us back to their record-
large short position in T-note futures.

The fact that the Commercials are holding an extremely
large net-short position in 10-year T-note futures does not
mean that the Treasury market is about to tank. But neither
does it mean that it is NOT about to tank. For the last few
months, the Treasury market has been enjoying the favorable
tailwinds of falling inflation expectations, evaporating
rate-hike expectations and record-high foreign buying.
Every bond market analyst on CNBC now seems to know that
interest rates are heading lowing. Likewise, every investor
in America now seems to know that interest rates are
heading lower...Every investor except for the commercial
traders of T-note futures.

Perhaps, and we are only guessing now, the commercial T-
note traders believe that the 10-year Treasury note is
already priced for perfection. Perhaps they believe that
the 10-year's lean 4.77% yield already reflects a world of
falling inflation, falling interest rates and eager foreign
buyers. If any or all of these favorable trends were to
slacken or reverse bond prices could fall rather quickly.
But again, we are only guessing.

Yesterday's sharp 1.3% drop in producer prices certainly
supports the inflation-is-falling theory. Thanks to a
stunning 22% drop in gasoline prices during the month of
August, producer prices fell by the most in three years.
The drop in producer prices is certainly welcome, but it
probably is not repeatable. Gasoline price did not fall
another 22% in September and they are unlikely to fall 22%
in October. In fact, they are already rebounding, as are
the prices of all other energy products.

Meanwhile, the Federal Reserve's various mouthpieces have
been dampening hopes of near-term rate cuts. "The bottom
line is this: With inflation too high, (monetary) policy
must have a bias toward further firming, "San Francisco Fed
President Janet Yellen declared early last month. Several
other FOMC members have echoed Yellen's lip-service to a
tight monetary policy (Read: high interest rates).

If, therefore, the perfect environment for bond-buying is
becoming slightly less perfect, foreign bond-buyers might
become slightly less enthusiastic. During the month of
August, international investment in U.S. securities swelled
to a record $116.8 billion – more than triple the July
tally. Purchases of Treasury securities, alone, totaled a
whopping $46.3 billion – more than seven times the July
tally. These hefty Treasury purchases certainly helped to
fuel the bond market's mid-summer rally. But we would be
surprised to see foreign investors toss $46.3 billion into
the Treasury market EVERY month.

We do not know why the Commercials are holding such a large
net-short position in T-note futures. We do not know why
they are betting so heavily that T-note price will fall.
Perhaps they realize that perfection often yields to
imperfection, and that imperfection often produces lower
prices...But we're only guessing.

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And the Markets...