As waves of capital poured into U.S. Treasuries this year, causing bond yields to fall precipitously, the flight-to-quality trade sparked fears of recession and worse.

Federal Reserve officials registering inflows into Treasuries as a sign of investor fear had to soothe markets with talk of interest rate cuts.

Bond markets, anticipating future rate cuts, saw more capital inflows.

Treasury prices rose further with the bond rally, lifting stocks back up toward record territory.

That’s what everyone sees on the surface, but there’s a lot more to the story, and it’s not all good.

Here’s the real backstory, how we got to where we are today, and what’s likely to happen next…

How Capital Flow Changes Everything

As U.S. equity markets recovered from their October 2018 to December 2018 swoon, thanks to the Federal Reserve reversing its rate-hiking regime with dovish promises, global investors nonetheless worried about economic growth everywhere else.

Signs of decelerating global growth weighed on market sentiment, causing international markets to sputter and decline.

Manufacturing metrics dipped lower across regions as purchasing managers’ indexes (PMIs) in Japan, Europe, and China fell below 50, the line in the sand between expansion and contraction.

Economic data in China pointed to weakness, despite serious stimulus measures. Slowing retail sales and a larger-than-expected decline in industrial production scared investors, who worried the trade war with the United States might sink China’s economy.

Meanwhile, the U.S. index – still above 50 – fell over two points to its lowest level in nearly a decade.

International investors began reducing their foreign equity exposure, opting to park capital in safe-haven U.S. Treasuries.

As capital flowed into Treasuries, U.S. institutional traders saw an opportunity to create an easy momentum trade with consequences they’d benefit from immensely.

They drove a tsunami of capital into the Treasury market, particularly into 10-year Treasuries.

Capital inflows into the 10-year Treasury moved prices higher, which lowered the bond’s yield.

Other investors, the financial media, and of course the Federal Reserve started worrying that investors were increasingly plowing money into Treasuries in anticipation of a protracted trade war with China, a recession, and an equity market sell-off.

During the month of May, as the stock market backtracked, setting off alarm bells, investors poured another $17.2 billion into bond funds.

And big traders plowed more money directly into the 10-year as part of their “momentum” trade.

Bond Prices Kept Rising While Yields Kept Falling

From January 2019, when the 10-year Treasury yield was 2.79%, to June 1, when the 10-year yield has collapsed to 2.08%, more than $100 billion flooded into the bond market.

The big-boy traders got what they wanted. Using shaky investor sentiment and weakening equity markets in May, they drove the 10-year yield down enough to catch the attention of the Federal Reserve, which had to step in and address the seeming flight-to-quality trade into Treasuries as recession fears and equity market fears overwhelmed them.

So, they did what they do, being the reactionary market-fluffing fools they are, and they re-upped their commitment to not hiking – and to cutting if necessary.

Chair Powell said, “We are closely monitoring the implications of these developments for the U.S. economic outlook and, as always, we will act as appropriate to sustain the expansion.”

Following Powell’s comments, the 10-year Treasury yield dropped to a 20-month low, and stocks and bonds rallied.

That bond rally is what the big traders had set up so perfectly. They started selling their positions as other investors dove into bonds anticipating a rate cut.

In the end, they played the Fed perfectly and reaped huge profits in the process.

After this Wednesday’s Fed statement and dovish rhetoric by Chair Powell in his presser, the 10-year Treasury dipped down to yield 1.99%, and stock markets around the globe rallied.

U.S. stocks soared with some benchmarks marking new highs.

That’s how the Fed gets played. That’s how capital flows change everything, but with the way things are moving, I don’t expect it to stay that way for much longer.

This market just hit another major acceleration point, so you may only have today to lock in your ground-floor opportunity.

Trust me – this isn’t something you want to miss. What’s going to happen next isn’t what anyone expects.

So enjoy this bond and stock market rally, because they’re coming to an end.

— Shah Gilani

Source: Money Morning