Bearish Trader Sentiment Bullish for Bonds

By: Levente_Mady

The bond market started the week with a decent tone but it pulled back on Thursday as the Treasury announced the details of next week’s bond auctions. In spite of the pull-back, the Long bond managed to eke out a small gain for the second week in a row. Real rates in the long end remain on an increasing trend as CPI declined from -.7 to -1.3% year over year through May causing the real long bond yield to close in on 6%. 

I cannot emphasize enough the detrimental effect that rising real rates will have on economic activity.  With the Fed Funds Rate already at 0 and longer dated bonds under pressure, the effect of Quantitative Easing has been negligible thus far.  I am certain this topic will be a point of focus at the Federal Reserve Bank’s policy setting Open Market Committee (FOMC) meeting next week.  With unemployment still rising and inflation deflating I expect no action on the interest rate front from the Fedsters. 

Treasury supply is an ongoing theme in the market these days.  Next week will be no different.  On tap will be another $100 Billion+ 2-5-7 year notes scheduled for auctions on Tuesday through Thursday.  While supply may put a lid on the market for the early part of the week, it is a known factor and the market has now factored in several Trillions of dollars of new issue notes and bonds for this year.  In other words, it is front page news; it has been front page news for months now and it is pretty much fully discounted for that reason.

Meanwhile in the real world, we had 3 more banks shut down by the authorities this weekend.  That takes the count up to 40 and counting for this year.  While the authorities managed to prevent a financial meltdown, everything is obviously not well in the world.  The record debt burden is not going anywhere.  As a matter of fact, it continues to grow.  Total debt (individual + corporate + government) in the US is closing in on 400% of GDP.  Previous to this debt cycle, the highest the debt to GDP ratio got was 250%.  Interest rates have hit rock bottom and Quantitative Easing is not addressing basic fundamental problems such as debt burdens, consumers losing their jobs and industrial production declines.  The deleveraging has certainly started in the private sector.  However, debt is not just disappearing; it is getting transferred from the private sector to the government’s books.  Eventually it will be the private sector that ends up paying for that debt. 

NOTEWORTHY:  The economic calendar was a mixed bag last week.  The New York Manufacturers’ Survey hinted at further slowing, while the Philadelphia Fed’s Manufacturing Survey improved by a whopping 20 points to a still negative -2 reading.  Housing Starts jumped 17% and Building Permits increased 5% in May.  On the other hand, homebuilders’ confidence declined a point to a dismal 15 for the same period.  I suppose they – the builder’s – are out there building them, I am just not quite sure how many folks are lining up to buy them…  The inflation data was lower than expected as the year over year figures continue to plunge further into negative territory.  As per the comment above, CPI is declining at a 1.3% rate, while PPI is dropping 4.5% over the same time frame. 

The news was all bad on the industrial front.  Industrial Production declined a worse than expected 1.1%.  The streak of declines is at 7 months on this front – with only one lone positive reading since the beginning of 2008.  Capacity Utilization continues to set record lows – the latest one at 68.3%.  Weekly Initial Jobless Claims ticked up 3k to 608k, while Continued Benefits dropped a substantial 148k to 6.69 Million.  Leading Economic Indicators improved 1.2% for the second consecutive month.  In Canada, the inflation picture is similar to the US.  Canadian CPI increased 0.2% in May as the 12 month figure dropped to essentially unchanged.  Canadian Retail Sales fell 0.8% in April, leaving the annual decline at 6.2%.  That is not good news for the economy.  This week’s schedule will include housing data as well as the Durable Goods report and new information on Personal Income and Spending.

INFLUENCES:  Trader sentiment surveys stayed in bear territory this week.  This is supportive from a contrarian perspective.  The Commitment of Traders reports showed that Commercial traders were net long 336k 10 year Treasury Note futures equivalents – an increase of 25k from last week.  This is still somewhat positive.  Seasonal influences are neutral this week before turning positive into month end.  The technical picture is improving as bonds are working on forming a bottom.  The 10 Year Note yield held the 4% level from the previous week, but ran into trouble as it tried to bounce.  We should get some follow through to higher prices during the weeks ahead.

RATES:  The US Long Bond future moved up a half point to 114-27, while the yield on the US 10-year note decreased 1 basis point to 3.78% during the past week.  The Canadian 10 year yield was 1 basis point higher at 3.51%.  The Canada-US 10 year spread shrank 2 basis points to 27.  The US yield curve was stable as the difference between the 2 year and 10 year Treasury yield increased 5 basis points to 258. 

BOTTOM LINE:  Bond yields declined a touch last week, while the yield curve was slightly steeper.  The fundamental backdrop remains weak, which is supportive for bonds.  Trader sentiment moved further into bearish territory – which is positive; Commitment of Traders positions are slightly supportive and seasonal influences are bullish.  I recommend keeping the long bonds that were purchased the other week.

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

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