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By Rom Badilla, CFA – Bondsquawk

There is something about fund managers and strategists who constantly believe that there is this mythical average or mean in the markets. Perhaps it comes from our study of economics where there is a natural balance of opposing forces of supply and demand, i.e. equilibrium. I am sure it exists (that is, in a vacuum that is devoid of investor’s time horizon). However, in my experience as a fund manager of close to 15 years, equilibrium has always been elusive.

On Friday, JP Morgan recommended that the flight-to-quality bid we have seen in the Treasury markets will eventually fade and rates will sell off. Their Fixed Income Markets Weekly, dated April 30, 2010 stated:

“Thus, this week’s flight-to quality bid likely reflects fears around the potential for Greece’s fiscal issues to snowball into a European banking crisis, something we believe policymakers will almost certainly seek to avoid. Indeed, the late-week rally in Greek spreads as well as the Athens Stock Exchange index suggests that markets are beginning to price in this expectation as well. Thus, flight-to-quality pressures are unlikely to sustain low Treasury yields. In sum, given these factors, we now turn underweight duration”

In addition, J.P. Morgan’s Treasury Client Survey which includes institutional fund managers are 92 percent neutral or bearish on U.S. Treasury prices implying that Greece is not an issue and the U.S. is on the road to recovery.

According to a Bloomberg survey of economists, the Federal Reserve will be increasing rates by quarter point increments as early as the 3rd Quarter of this year.

Obviously, no one sent JP Morgan and many of the institutional world the memo of Greece contagion and the possible demise of the Euro. Let’s not forget what is happening in China as the government sent another round of tightening.

Flight-to-quality trades occur when uncertainty hits the market. In this case, we don’t know how deep the rabbit hole is. What was once rational becomes emotional as fear overcomes investor’s decision making. So when investors start looking for the exit, not only do they run but they “George Costanza” it and run people over in the process. This explains the crashes that occur throughout history and recurring black swan sightings.

Typically, option volatility spikes as market participants drive up the price for options as a hedge against current positions. Sometimes, investors will do whatever it takes to protect the farm. Below is the Merrill Lynch MOVE Index that captures option volatility for Treasuries across the curve.

Merrill Lynch MOVE Index – 2005 to Today

As you can see, volatility spiked in 2007 and lasted for almost a year. After subsiding, volatility spiked again as the bear market took shape in the fall of 2008 before subsiding the following January. If you go back further to the early part of this decade, you can see more spikes that last equally as long.

Merrill Lynch MOVE Index – 2000 to 2005

Uncertainty and flight to quality trades certainly fade. There is no doubt about that since mathematically volatility cannot go in one direction forever. The only question is how long will it take to subside. Given the severity of what is happening in Europe and the possibility of contagion among developed markets, uncertainty, high volatility and flight-to-quality trades might last for awhile. There is nothing elusive about that. The situation is real. This much is certain.