Kuroda's conundrum

Imagine that you are Haruhiko Kuroda.  Appointed by a once-failed prime minister keen to redeem himself, you have been given carte blanche to reverse two decades of stagnation and to attach a monetary defibrillator to the sclerotic heart of the Japanese economy.  Emboldened by this mandate, you embark on a program of shock and awe, injecting an unprecedented level of public sector involvement into bond and equity markets.

For a while, your quantitative and qualitative easing (QQE) program is a success, as the yen weakens, growth improves, and inflation moves higher.  Happy days!  You stay with the program, making a few minor adjustments along the way.

A funny thing happens on the way to escape velocity, however;  you find that you own an uncomfortably large swathe of financial assets, some of which (JGBs) are desired and needed by the private sector.  At the same time, your economic recovery runs out of puff; sure, some weakness was to be expected after the consumption tax hike, but not the tepid, stop-start pattern of the last couple of years.  Meanwhile, consumer price inflation has headed back south; yes, oil prices have played a part, but core ain't lookin' too hot, either.

While markets expect you to deliver some further easing, you realize that you may be coming close to doing more harm than good by taking JGBs out of the market.   So you decide on a little more shock and awe (well, more shock than awe) by surprising the market by imposing a negative interest rate on some central bank excess reserves.   Let's see how the banks like that one....


...whoops, that's more like shock and awful.

Meanwhile the yen surges, inflation continues to slide, and pressure mounts for you to do something.  However, you've been around a long time and know that engaging in half-assed measures simply for the sake of being seen to do something isn't the way to succeed.   So you take the summer off....but thanks to the shilly-shallying of the Federal Reserve, the dollar's on the back foot and pressure on the yen is pretty unrelenting.

So now it's September, and after the disappointments of the last couple of meetings, what do you do?   More bond purchases would seem to be a non-starter, especially as generating a flat yield curve at or below zero is a disaster for a nation of elderly savers such as yours.  Your organization has let slip that a steeper yield curve could offer some benefits (to both savers and banks), but how do you manage that?

*  Do you simply quit budgeting your bond buys across various maturity buckets, which would presumably allow you to focus on buying short dated paper, thus allowing long end yields to drift higher?

* Do you actively look to shift the composition of your portfolio by actively selling duration to the market while buying that short dated paper?

* Do you shrug your shoulders and say "in a for a sen, in for a yen" and cut rates again?

* Do you try more of the same and check yourself into the local asylum?

It's a tricky one, to be sure; many of the policy options facing the BOJ either risk being dismissed as trivial or  carry side effects that could have a bigger impact than the medicine.  Complicating matters, of course, is the collapse in foreign bonds' yield premium over JGBs when hedged back into yen.  This indicator has gotten a fair amount of air time recently, given that the hedged yield on 10 year UST briefly turned negative a few weeks ago and remains perilously close to zero today.


This isn't actually all that rare, as it is simply a function of relative yield curve shape and cross currency basis.  Obviously it's just another reason to shake one's head in an era of ZIRP and NIRP, but the Japanese have faced this situation on several prior occasions.   Their options are either to sell the Treasuries and bring the money back home, buy back some of their currency hedges, or accept the temporary negative carry.   Of these the last is unpalatable over long periods of time and the middle one is a lot easier when yields are 6.5% instead of 1.5%; there simply isn't enough interest income to pay for currency risk.   Perhaps that's why we've seen Japanese investors sell foreign bonds over the last couple of weeks.

 
So the million dollar question is whether this matters for the yen.   Historically, it does...unless it doesn't.   Over the past 25 years, several big cycles in USD/JPY have coincided with shifts in the yield premium of hedged USTs over JGBs.  Then again, there was a lengthy period from 2005 to roughly the beginning of Abenomics in which there was no correlation at all.


Perhaps we can chalk this up to shifts in Japanese investor behaviour.  Certainly in the middle of the last decade, Japanese investors were considerably more comfortable running unhedged bond positions than they are now, both because of the gross yield of USTs and the perception of the yen's trajectory.

Should the BOJ move to steepen the domestic curve, that would, all else being equal, strengthn the yen under this framework.   Of course, all else is rarely equal, be it hedge ratios or, perhaps more pertinently in this case, the yield on Treasuries.  Of course, if the BOJ does nowt, a rally in longer dated JGBs could remove some of the selling pressure that's assailed the Treasury market in recent weeks, particularly if the Fed is anodyne tomorrow.

For choice, Macro Man reckons that they will do something to try to juice back end yields, perhaps accompanied to a modest deposit rate cut.  On balance, that would probably be a negative for the yen, but not a table pounder.  he could easily see a scenario where spot jumps around a tremendous amount and doesn't end up too far from where it started.

Either way, strap in.  it should be a fun ride.
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theta
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September 20, 2016 at 9:56 AM ×

If you really want to start inflation you need to do fiscal easing. If you don't have control over that, then within the monetary realm you stop buying domestic assets, double the size of QE, and buy foreign assets instead, and announce that all income from said assets will be wired to central government so that they can ease taxes or increase spending.

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Justabeancounter
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September 20, 2016 at 10:15 AM ×

Indeed theta. Interestingly enough I'm pretty sure I advocated a kind of reverse twist in this very blog some time ago. However with the short end so low not sure we need to buy at the short end. So I'd advocate selling the long end with a floor so that if demand gets too high they can keep a target yield range to keep the steepness they wish. I assume the Govt would have to issue them enough jgbs to sell. The proceeds could be used for tax cuts, spending et al.

Feel free to pick through the flaws!

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Spctr
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September 20, 2016 at 11:15 AM ×

For Japan to survive, it needs real 'unconventional' fiscal policy, no more monetary policy alchemy!
When I say unconventional, I mean promoting birth rates through direct subsidy to families - in size - $1 million per newborn. You'll get both consumption and birthrate up.

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washedup
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September 20, 2016 at 12:38 PM ×

There is a very strong market consensus that the Fed will do absolutely nothing while the BoJ will try something radical. The reason for that is markets are 100% sure central bankers care about them to the exclusion of everything else, including their credibility.

What would improve the credibility of both institutions the most, ironically, is the exact opposite of the above actions - namely that the BoJ avoids looking like a headless chicken by throwing more spaghetti at the wall and instead says look, you are just going to have to wait while these past actions bear fruit, while the Fed, raises a measly 25 bps and says WTF are u surprised about after all those speeches we made?

I don't think this is a usual trade-off either - due to the unique confluence of where markets, politics, and the economy stands, these meetings are a bit of a waterloo in that credibility vs mkt friendliness tussle.

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Nico G
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September 20, 2016 at 12:46 PM ×

Spctr

finally, FINALLY some common sense here

the BOJ can ease quadrillions of trillions of yen and buy the whole exchange and send 10000 money helicopters and then what? their population is still aging and to boot, Japanese youth absolutely lost any interest in having sex

it is all about demographics in Japan and the picture is horribly dire. Congratulations for stating the obvious because too many peeps are just wasting too much time on quantitative analysis. ENOUGH of this CB nonsense.

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12yo HFM
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September 20, 2016 at 12:49 PM ×

https://www.youtube.com/watch?v=d0nERTFo-Sk&feature=youtu.be

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Polemic
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September 20, 2016 at 1:21 PM ×

Japan is a retirement home. Japanese overseas investments are their pension plan and the jpy itself is just a token for the adult daiper machine.

Great write up though MM.

I'm gunning the short jpy possie into this. Mkt doesnt feel as though they have any faith in JP policy anymore so I ll back the position plus surprise trade by being short jpy.

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Anonymous
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September 20, 2016 at 2:46 PM ×

theta 9:56 AM "If you really want to start inflation you need to do fiscal easing."

No, you just copycat Huge Chavez and Nicolás Maduro

WSJ:Venezuela’s Inflation Is Set to Top 1,600% Next Year

Why doesn't anyone see this?

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checkmate
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September 20, 2016 at 3:09 PM ×

Shame central banks don't have a policy that stops old bastards like me getting even older and spending less and less because I've already got what I need and long ago lost interest in most of the things that keep the plastic cards running hot when you are younger. Multiply me by millions and you have the Japanese problem summarised.
They also now have another problem though as MM touches on. In a world of ZIRP and NIRP Mrs Watanbe who in the past has sent money overseas to work is being nuked by competition from their equivalents in just about every developed country seeking to do the same thing.
Subsidised sex appears to be very rational way to go, because their monetary policy options won't eke out any advantage past the next round robin of central bank meetings. Game over.

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Anonymous
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September 20, 2016 at 3:47 PM ×

I feel good already this morning:

Deutsche Bank sparks sell-off across banking sector. Default probabilities jump.

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Anonymous
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September 20, 2016 at 3:52 PM ×

This thing is looking up for me. I will be booking more profits this week than in the last 5 years. You can always depend on the absolute greed and stupidity of bankers especially DB

DB: 5y default probability jumps to almost 19%.

WFC a little gold mine right now too.

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scepticus
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September 20, 2016 at 4:25 PM ×

Monetary policy targeting birth rate; what is the appropriate central bank easing euphemism for that?

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Anonymous
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September 20, 2016 at 4:40 PM ×

please no cb euphemisms, i do not want grandma yellen anywhere that context

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Anonymous
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September 20, 2016 at 5:34 PM ×

Japan needs to do a complete about face and open its borders to massive immigration. But, alas, there is zero chance of that happening!

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CV
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September 20, 2016 at 5:57 PM ×

Completely agree on pro-natal policies in Japan. Here is the thing ... non-economist social scientists have been calling for this for a looong time. The problem is that these policies don't work very well, and only work with a significant lag. But I agree in the main.

The key is to incite women to have children earlier, preferably while they are studying. Pay them is what I say. That counteracts the tempo effect (birth postponement essentially). But if the quantum effect is strong enough, it is difficult. One of the main reasons for low fertility in Germany and the CEE, for example, is simply that the desired family size is low among women, or so at least the sociological explanation goes. Also note, that the literature here talks about a "fertility trap" which tends to operate once countries' TFR falls below 1.5. Two countries, Denmark and France, have escaped, but elsewhere it hasn't happened or it is taking a very long time to do.

Finally, if Piketty et al are right, the situation for working age families are getting more precarious which in itself tends to lead to birth postponement. This "missing births" effect exerts its effect over generations. The demographic transition is like a tidal wave, it isn't easily reversed.

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CV
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September 20, 2016 at 6:00 PM ×

Meanwhile, on the BOJ. I have been pushing the "Reverse Twist" story hard, but I fear that the talk has been cheap. We will see. The spectrum of expectations for both the BOJ and the Fed are wide, so someone will be positioned very badly no matter what. God, it will be fun!

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Leftback
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September 20, 2016 at 6:03 PM ×

If neither BoJ nor the FOMC do anything material (Hilsenrath "leak" just confirmed the latter in the WSJ), does the yen rally? Or is that priced in?

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CV
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September 20, 2016 at 6:06 PM ×

Re the JPY LB, I lean towards Polemic's view. JPY shorts have already been buried in the woods and investors have lost faith in the BOJ ... I think the bar for a further plunge in USDJPY is higher than for a rally. I haven't look at positioning though, and in any case ... I am not sure how the lemmings and pajama traders are positioned here. That probably matters given the huge divergence in expectations.

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scepticus
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September 20, 2016 at 6:35 PM ×

Of course, in the wider context a moderation of population growth and perhaps a little de-population in already crowded places ought to be cause for optimism, especially where it co-incides with an improvement in GDP per capita. In a sane world, sacrificing these developments on the altar of investment returns or nominal gdp growth would not be countenanced for a second.

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washedup
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September 20, 2016 at 6:58 PM ×

LB - I am with Pol/CV - honestly don't have much to bolster the argument other than positioning being ridiculously lopsided towards yen strengthening, so we either get a buy the rumor sell the news selloff, inaction selloff, or steepening selloff - their equity markets are closed for a couple of days though so the impact may be more muted off the gate.
Interesting implications for bucky given where SHIBOR and HIBOR currently are.

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Mr. T
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September 20, 2016 at 7:06 PM ×

...meanwhile in other news DB is a couple ticks below its brexit lows, and oh my eyes reading the BMPS recap plan. If Europe is following JP banking, these NPL portfolios are going to be hanging around forever. Is it really possible that BMPS was that much worse than everyone else? I believe the price is 27 cents on the dollar for ~$30B book.

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Anonymous
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September 20, 2016 at 7:14 PM ×

Anon 5:34 "Japan needs to do a complete about face and open its borders to massive immigration."

They are bringing in more worker drones to take up the resulting labor market slack...up to a million this year

http://www.japantimes.co.jp/news/2016/04/02/national/japan-to-have-record-1-million-foreign-workers-this-year/#.V978kqIrJGE

At least Japan is doing it because they need workers as opposed to the United States' present open borders policy and allowing one million legal immigrants per year in the face of 94 million people of working age not working and another 10 million looking for work. So who is committing suicide here?

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JMT
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September 20, 2016 at 8:04 PM ×

I'm with the consensus that the Fed does nothing tomorrow, having missed the opportunity, laying the groundwork for a likely Dec move...

However, in line with "washedup's" comments, I would not be surprised if they tighten as they need to make a statement that they are in charge, and that all the prognosticators claiming that the Fed never moves unless it is > 70% priced in need to be given a reality check. The Fed have never hesitated to ease rates when necessary! Tightening, of course, is removing liquidity but with rates so low this is practically immaterial. (Ignoring Brainard, there has been of plenty of hints, especially Stanley 'pretty strong case' Fischer.)

A move along with a revised dot-plot showing a consistent lower terminal rate, along with a dovish BoJ, should result in a weaker JPY and not be too disruptive for the equity markets, assuming Dec is perceived to now be off the table. (I'm of the view though, that equities are in for a shakeup as the 'Brexitty' election approaches!)

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Anonymous
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September 20, 2016 at 8:25 PM ×

Well although everyone knows that Fed is likely do nothing tomorrow, almost everyone also knows that Fed will do something in Dec. Several had said so on CNBC. So if the market is efficient and adjusts according to expectation, it should aim at the Dec hiking right after the Sep statement. And since everyone knows this already, the reaction to FOMC should be really muted.

Regarding Japan, why does the Japan gov have to do anything? It seems to me that their unemployment rate and private wealth are in a good place. Most countries would only envy their positions. Maybe they need some policy to encourage birth rates. Other than that, why even bother?

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Anonymous
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September 20, 2016 at 11:08 PM ×

I still think the fed move in Dec is dependent on the upcoming data, with a new president I can't see them tightening upon the new administration. I really don't think the fed are in any hurry.

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Anonymous
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September 20, 2016 at 11:40 PM ×

Japan will come out on top...what country needs more people?


“By 2021 a disruptive tidal wave will begin. Solutions powered by AI/cognitive technology will displace jobs, with the biggest impact felt in transportation, logistics, customer service and consumer services,” said Forrester’s Brian Hopkins in the report.

"By 2021, robots will have eliminated 6% of all jobs in the US, starting with customer service representatives and eventually truck and taxi drivers. That’s just one cheery takeaway from a report released by market research company Forrester this week.
These robots, or intelligent agents, represent a set of AI-powered systems that can understand human behavior and make decisions on our behalf. Current technologies in this field include virtual assistants like Alexa, Cortana, Siri and Google Now as well as chatbots and automated robotic systems. For now, they are quite simple, but over the next five years they will become much better at making decisions on our behalf in more complex scenarios, which will enable mass adoption of breakthroughs like self-driving cars."

https://www.theguardian.com/technology/2016/sep/13/artificial-intelligence-robots-threat-jobs-forrester-report

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johno
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September 20, 2016 at 11:55 PM ×

Nice put-yourself-in-Japanese-shoes analysis, MM. Not sure what they'll do, but the data the past couple weeks from the MoF and yen action suggests they're, at the margin, selling treasuries rather than taking off FX hedges to run unhedged.

My view is hardly worth writing, but ... I'm guessing the BoJ just says that negative rates are fine, that they'll cut more negative if required, and that 2% remains the target, to be achieved at the earliest time. Maybe they cut rates 10-20bps. The surprise-the-market game has backfired badly and with a three-way split board, I question whether Kuroda could carry a surprise policy change even if he wanted to. The biggest question for me - even bigger than whether they affirm negative rates or cut them by 10bps - is what they say about the yield curve. They have so lost control of the narrative this year (yen and inflation expectations going 180 degrees the wrong way) that you wonder whether they're going to stick their necks out again and explicitly target the curve shape. Their credibility is already so low and they could easily mess this up, being too explicit or too unclear. If they don't like the curve shape, maybe they should just adjust their purchases along the curve without setting explicit targets, as they've been doing recently.

Good luck tonight, all!

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Hotairmail
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September 21, 2016 at 12:34 AM ×

I think they'll do what we all expect. Fed - nothing with a likelihood of Dec. BoJ to trial curve steepening. Market relaxes and becomes happy.

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Polemic
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September 21, 2016 at 1:20 AM ×

If boj steepen the curve then i guess BTPs and other eurocrap that japanese investors have been piling in to fall.

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Leftback
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September 21, 2016 at 2:49 AM ×

No-one is going to do anything….

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Fired Macro PM
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September 21, 2016 at 3:04 AM ×

I'm with Johno. Absence of headline that shock, usd/jpy will dip but it will be much shallower as we've all become use to this. I plan to sit this one out, and I won't certainly chase a pop either (unless its really the "shock") but if the pair dips to 99.5-100, i will be stepping in to buy.

I think that will be the final low for the pair for a foreseeable future.

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johno
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September 21, 2016 at 3:49 AM ×

This will be interesting. While I have some view on the policy outcome, I have no view on how USDJPY trades. FMPM may well be right about the 99.5-100 level, but I'm not ruling anything out at this point. I'm also as interested in how the ultra-long end trades as in the USDJPY action, maybe more.

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Fired Macro PM
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September 21, 2016 at 4:04 AM ×

C'mon Koruda... so sick and tired of the "we will report anytime within the 2 hour window" bullshit.

I got dishes to do, shows to catch up on.

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Fired Macro PM
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September 21, 2016 at 5:28 AM ×

I'm chasing this. I love the price action.

In @ 101.90.

Lets go.

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Fired Macro PM
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September 21, 2016 at 6:35 AM ×

Taking half off here at 102.75.

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johno
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September 21, 2016 at 7:00 AM ×

Nice trade, FMPM. Figured no rate cut and sensitivity to yield curve was bullish for stocks, so went long futures. The action I wish I'd monetized is in the US 30Y bond futures. Someone else out there gets a shiny medal for that. Interesting that the JGB 10s/30s curve is actually 2.6bps flatter on the day! The headline read 'scrapping average maturity target' and 'yield curve control.' "Sell the 30y!!" And then you read the statement ... targeting zero for the 10y and in a footnote they say they'll act to prevent the yield curve from deviating 'substantially from current levels.' "Buy 'em back, buy 'em back!"

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Fired Macro PM
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September 21, 2016 at 7:25 AM ×

hey johno, I'm about to close the other half before i go to bed. i hate solely trading on price action but sometimes thats all you get when market is lukewarm about the changes. the momentum has now stalled and there's obviously FOMC in 12 hours. The upside is probably done at this point. i rather get my 6 hour sleep in peace and take on the Fed in someway that doesn't make me bleed out the little money i made tonight lol.



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johno
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September 21, 2016 at 7:36 AM ×

Thanks for the heads up, FMPM. I actually closed my futures position at the close. Agree re the price action and looming Fed.

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