US Treasury's Retain Steepening Yield Curve Trend

By: Levente_Mady

The Treasury market is on a tremendous winning streak: it is up for the second week in a row! Safe haven flows continue to dominate as bonds strangely trade higher in step with increasing energy prices. The financial sector continues to melt away in spectacular fashion as the US stock market looks to be heading for one of its top 10 largest monthly drops ever. Credit spreads remain under pressure and liquidity is not improving. Quarter end window dressing will definitely not help the sectors that have been beaten down at least for the next few days.

For more details on my view in the economy and Central Bank activity, feel free to have a peek at my interview from this past Friday on the Canadian Business News Network at the following link: http://watch.bnn.ca/trading-day/june-2008/trading-day-june-27-2008/#clip63214 .

The FOMC left the Fed Funds rate unchanged, surprising nobody with that course of action. There was more saber rattling on the importance of being vigilant on inflation, but they actually tried to sell the market on the idea that downside risks to economic growth have diminished somewhat. As quarterback par excellence Joe Theisman once said: “You don't have to be a Norman Einstein to figure this one out!” The Fed is toothless and the market blatantly thumbed its nose at Bernanke and Co. with its reaction to the Fed statement. Short term rates dropped like a stone and so did the stock market. That is not exactly the reaction one would expect with diminished risk of the economy falling off a cliff and tough talk on inflationary pressures. After the sharp rally in the front end of the yield curve, I have increased confidence in my forecast that the Fed is months if not years away from changing the Fed Funds rate and when they do, they will be more likely lowering - not raising rates as the consensus would have you believe at this point.

Early in May I first recommended to buy bonds and sell stocks in a spread trade. Last week I suggested that you should take your money and run. I was a tad early, but according to our models at this point stocks look almost 2 standard deviations expensive to bonds, so the bulk of the profits in that trade have been realized as far as I am concerned. The other trade idea to buy short term bonds - sell long term bonds, i.e. the yield curve steepening trade – improved a smidge for the second week and it continues to make sense.

NOTEWORTHY: The economic data calendar was on the weak side again last week. The latest Consumer Confidence surveys both declined to multi decade lows and they were reported below expectations. The Conference Board survey's future expectations component crashed to the lowest level in the history of the 44 year history of this data series. Interestingly, that is the best predictor of consumer behavior going forward. Durable Goods Orders were flat in May, but they are negative year over year. New Home Sales declined 2.5% last month to 512k.

The new home inventory is sitting at a massive 10.9 months. May Existing Home Sales are stuck near 5 million units while the 10.8 months supply remains very high and consequently prices remain under pressure. Wee kly Jobless Claims were stuck at 384k last week. The 1.9% increase in Personal Income is a bit of a mirage as it is driven by the one time event sponsored by the US government. Needless to say, consumers were out there spending those funds as fast as possible. Next week's headliners will include the usual beginning of the month data such as the ISM Surveys and the Unemployment report which will be one day early due to the July 4 th holidays.

INFLUENCES: Trader surveys remain in neutral territory on bonds during the latest week. The Commitment of Traders reports showed that Commercial traders were net long 420k 10 year Treasury Note futures equivalents – a decrease of 56k from last week. The COT data is providing the bond market with a strong tail wind. Seasonals remain positive for another week or so before turning negative as we get past the first couple of trading days in July. After trading up to 4.30% 2 weeks ago, the 10 year note yield settled back under 4%. The positive factors remain dominant, so as long as the 10 year yield manages to stay under 4%, the bias will be bullish on the technical front also. I would love to see a positive reaction to a weaker than expected Employment Report and sell into that strength heading into the long weekend.

RATES: The US Long Bond future traded up over 2 points to close at 115-21, while the yield on the US 10-year note decreased 17 basis points to 3.97%. The yield curve was slightly steeper and I am expecting that it will retain a steepening bias. Long-short accounts can take advantage of the steepening trend by buying 2 year Treasuries against selling 10 year Treasuries on a risk weighted basis using cash or futures. This spread increased 7 basis points to 134 during the past week.

CORPORATES: Corporate bonds remain overvalued, especially the weaker credits.

BOTTOM LINE: Bond yields dropped lower and the yield curve was slightly steeper last week. The fundamental backdrop remains bleak. Trader sentiment is neutral, while COT positions and seasonal influences are quite supportive. The recommendation is to stay with the curve steepener, and continue to shun the weaker corporate credits. My bond market indicators remain in positive territory, and I am expecting a few more days of positive market action (i.e. lower yields) as we head into month and quarter end.

By Levente Mady
lmady@mfglobal.com
www.mfglobal.ca

The data and comments provided above are for information purposes only and must not be construed as an indication or guarantee of any kind of what the future performance of the concerned markets will be. While the information in this publication cannot be guaranteed, it was obtained from sources believed to be reliable.  Futures and Forex trading involves a substantial risk of loss and is not suitable for all investors.  Please carefully consider your financial condition prior to making any investments.

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