Recognition of Reality

I had a hunch where this was going when the news was first announced end of 2009, but now my suspicion is even stronger.

Late last year the Treasury announced an unlimited backstop to Freddie/Fannie losses.

Anyone who has been following the Fed's QE program knows the Fed has bought nearly a trillion dollars of FRE/FNM ABS in the past year.

However these assets must be souring and thus the Fed itself taking the losses. They will have to do something lest the losses eat them.

The news now that FRE/FNM are buying back their securities, combined with the unlimited Treasury backstop, and the Fed now being probably the single largest holder of these securities, this arrangement may be for the Fed to offload them before they become the biggest troubled bank in the world.

Furthermore, the news is also the FRE/FNM maybe coming after the originating banks for flaws and fraud, thus forcing putbacks to the financials.

The extraordinary support that the Fed/Treasury has given to the markets is looking like a failure and is likely coming to an end.

http://www.bloomberg.com/apps/news?pid=20601087&sid=amgoNkv_GkYs&pos=1

http://freddiemac.com/news/archives/mbs/2010/20100210_pc_securities.html

http://online.wsj.com/article/SB10001424052748704343104575033543886200942.html?mod=WSJ_hps_LEFTWhatsNews

Oscillations and Stability

From earlier in the past week, I noticed the following short term formation.

I have seen this waveform before, on an oscilloscope, in a lab when i was still a student.

An oscillation of increasing amplitude, which i modeled with the equation x*sin(x)

Practically speaking, it is not a sign of stability.

Similarly, over longer terms there are additional indications of potential instability.

The VIX (volatility index), AKA fear index, measures option activity and has also been building a similar unstable oscillation, with each progressive volatility spike getting larger and larger.

This has the resulting effect on the market.

Notice each sell off getting progressively larger and on bigger volume.

Buyer beware.

Currents of Liquidity

-Early 2009

The global financial system borders the edge of total lock up.

http://zerohedge.blogspot.com/2009/04/incredibly-shrinking-market-liquidity.html

-March 2009

The Federal Reserve announces ~1.2T in quantitative easing (QE), the "printing money" to buy mortgage and US Treasury debt.

http://www.washingtonpost.com/wp-dyn/content/article/2009/03/18/AR2009031802283.html

Program/algorithmic/high frequeny trading has been an ongoing component of modern markets, but combined with newfound QE money and fewer "real" investors, the large financial firms more easily push around the market, almost straight up for the past 10 months.

http://en.wikipedia.org/wiki/Algorithmic_trading

http://online.wsj.com/article/SB124908601669298293.html

http://www.zerohedge.com/article/correlation-sp-500-performance-fed-monetization-activities-start-qe

Program trading has an average of ~25% the total NYSE volume and as high as 50%.

http://www.nyse.com/pdfs/PT06.22-06.26.pdf

-Early 2010

With the US dollar again closer to all time lows, the Fed has been trying to wind down QE.

At this level, the Fed likely cannot extend QE without the risk of a US currency crisis.

Under political pressure, the President threatens to reign in the financial's proprietary trading activities, to reduce financial system risk, with a new/partial Glass-Steagall act.

http://www.bloomberg.com/apps/news?pid=20601087&sid=aO0fD0twUTBk&pos=2

http://en.wikipedia.org/wiki/Glass%E2%80%93Steagall_Act

However, the proprietary/program trading is the very thing largely keeping the market afloat.

The same week the Dow dumps 500 points as QE money has been drying up and the financial companies' trading activities are in danger of being shut down.

http://www.zerohedge.com/article/beginning-end-wall-streets-various-prop-trading-desks

http://www.zerohedge.com/article/flush-hft-downside-bids-are-oddly-missing

Almost immediately after the market damage, Obama backpedals and says bank regulators may be too tough.

http://www.cnbc.com/id/35014931

There are also some rumors that proposed restrictions on prop trading already has loopholes, so the final effect is yet to be seen.

http://www.businessinsider.com/big-banks-have-already-figured-out-the-loophole-in-obamas-new-rules-2010-1

Either way, note again that despite the recent sell off, the market remains at relatively high levels on thin and falling volume.

This has been the one year machine driven rally, that less and less actual people believe in.

Back to the Future

A little expansion on the 1987 similarities.

Both then and now the US Treasury bond market and US Dollar were under persistent heavy pressure while the stock market was high.

Remember the inverse relationship between bond price and interest rate.

The resultant sudden spike in interest rates from bond/currency pressure suffocated the stock market rally.

1987 US Dollar index

1987 Dow vs 10 year Treasury rates

1987 Dow vs 30 year Treasury Bonds

2009 US Dollar Index

2009 TNX 10 Year Treasury Rate

2009 TLT 20 Year Treasury Index

Of course there are never guarantees in the capital markets but this has the markings of a dangerous juncture.

Potential Hysteresis Effect in Markets

A pattern I have noticed from the past and the present.

Tangent function in Matlab as an approximation of typical hysteresis response curve.

In 1987 the stock market may have exhibited a hysteresis response before the crash.

Stock market from March 2009 to present.

Maybe it is nothing, but the potential similarities are interesting to see.

http://en.wikipedia.org/wiki/Hysteresis

http://www.lassp.cornell.edu/sethna/hysteresis/WhatIsHysteresis.html

Year Is Still Young

Financial Crisis 2007 to Present.

I don't believe it is over, so I hope to start journaling some observations.

Thanks to my friends who encourage me to do something with my thoughts.