U.S. Treasury Bond market Severely Damaged

By: Levente_Mady

The bond market was severely damaged last week.  The theme from my previous note about the continued deterioration of the credit quality of government bonds and the consequent increase in real yields is certainly coming to fruition in swift fashion.  It all started on Wednesday when the Standard and Poor’s rating agency issued a credit watch (with negative implications – i.e. potential downgrade from the best available AAA rating) for bonds issued by the United Kingdom – also known as Gilts. 

Ironically, after a brief negative reaction the British currency started to turn around and strengthen along with most other currencies at the expense of the US Dollar and US Treasury bonds.  The word was out that a similar credit watch was imminent for US Treasury securities.  The rout was on for the rest of the week.  Add to this further supply concerns – the Treasury will auction in excess of $100B 2-5-7 year notes next week – and the situation looks quite bleak. 

As Uncle Bob (of the Hoye variety) mentioned in his notes this week, the REAL yield on Treasury bonds has gone from -1.5% to +5% and counting.  Bob is looking for real rates to head into double digits and I don’t disagree with him.  What he did not discuss in his last note is the devastating effect this will have on economic activity going forward.  For decades at the first sign of distress the Fed would come in and lower rates and force real rates to 0 or below.  That worked until nominal rates got to 0 (which is where we are now) and inflation stayed above 0 (i.e. deflation was avoided).  It is rising real rates that kill!  Let’s look at a brief real life example. 

If you bought a house and you are paying 10% interest (suppose it is one of those special deals where you put 0 down and don’t have to make any payments for the first 5 years), as long as the value of your house is rising by more than 10% - say 20%, you are making out like a bandit.  Your cost of funds (10%) is below your rate of inflation (20%), leaving your real interest rate at -10%.  On the other hand even if your interest rate is at 0% but the price of your house is declining (say at 10%) all of the sudden the real interest is at +10% and your mortgage is upside down – you owe more than what the house is worth.  Lights out, business closed.  If real rates are indeed heading into double digits, the snappy recovery that consensus is looking for will not materialize later this year, nor next year and possibly not even 5 years from now.

Meanwhile the financial sector continues to see signs of severe stress.  The steady stream of financial institutions (mostly banks and credit unions thus far) imploding was evident again last week.  A couple of banks in Illinois and BankUnited (the largest independent bank in Florida) were shut down and taken over by the regulators.  The count is at 36 and it does not appear to be abating.  If anything, it is getting worse as BankUnited is by far the largest institution taken down thus far. 

NOTEWORTHY:  The economic calendar was very quiet last week.  The few data points – mostly disappointing and therefore supportive for the market – were quickly discounted as the focus of the week was credit quality.  The week started off with a record low Housing Starts report.  In the 50 year history of this data series the 458k was the lowest number ever.  The data not only plunged 12.8% from March but it was also close to 20% below consensus forecast! So much for green shoots on the Housing Starts data.  Weekly Initial Jobless Claims remained elevated as they declined 6k lower to 631k, while Continued Benefits were up another 75k+ to 6.66 Million.  The Philadelphia Fed’s Manufacturing Survey was little changed at -22.4, forecasting further weakness in the manufacturing sector.  Leading Economic Indicators were positive for the first time in 10 months increasing 1.0% with help from a rising stock market and improving consumer sentiment.  In Canada, CPI inflation declined 0.3% to bring the annual figure to 0.4% and falling.  This week’s schedule will include data on home sales, Durable Goods Orders, consumer sentiment and the second cut at the Q1 GDP report.

INFLUENCES:  Trader sentiment surveys were stable this week.  While longer term this metric is supportive, in the short term it has more room to move before it becomes overdone.  The Commitment of Traders reports showed that Commercial traders were net long 434k 10 year Treasury Note futures equivalents – an increase of 57k from last week.  This is supportive.  It is also telling us that the smart money continues to accumulate long positions as yields rise.  Seasonal influences are positive.  The technical picture is still less than constructive as the market broke again for new lows for 2009.  As per last week’s comments, I am looking for yields to top out around the 3.5% on the 10 Year Treasury Note Yield (at 3.45% as of Friday).

RATES:  The US Long Bond future collapsed over three and a half points to 119-10, while the yield on the US 10-year note increased 32 basis points to 3.45% during the past week.  The Canadian 10 year yield was 16 basis points higher at 3.25%.  The US yield curve was sharply steeper as the difference between the 2 year and 10 year Treasury yield increased 29 basis points to 257. 

BOTTOM LINE:  Bond yields jumped sharply, while the yield curve was significantly steeper last week.  The fundamental backdrop remains weak, which is supportive for bonds.  Trader sentiment was stable in bearish territory – which is positive; Commitment of Traders positions are supportive and seasonal influences are becoming positive.  My bond market view is positive.

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

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