U.S. Treasury Bonds Positive Seasonal Influences

By: Levente_Mady

The bond market bounced back last week.  We went through another 3-10-30 year auction cycle, but the restless natives did not even wait for the auctions to be out of the way as the bond started its move up first thing on Monday.  Needless to say the supply was well received.  Not only was the bidding substantial and aggressive, but also the closely watched “International Buyers” showed up in force again.  They took over 50% of all the bonds auctioned and were especially aggressive in buying the 30 year tranche on Thursday. 

I was reading Richard Russell’s commentary on Treasuries Wednesday.  One of his ongoing pet peeves is the Treasury Bond market.  He wrote about how it makes no sense to be buying 10 Year Treasury Notes at 3.7%, but in the next sentence he explains that the answer may be the yield curve.  “If the banks can borrow at .25% and get 3.7% from 10-year T-notes, that's a 3.5% profit a year or 10% over three years” he wrote.  Well, that is certainly a part of the equation.  The other part is that with all the debt bubble overhang and resulting tighter lending standards, there are just not very many credit worthy customers to lend to out there.  So the banks take their deposits and plow them into the safety of the Treasury market securities.  The third reason is that in spite of all the liquidity that has been pumped into the system deflation seems to dominate (for more evidence see the comment in the economic section below on productivity) the scene.  This is causing real yields to increase – which makes Treasury Bonds increasingly attractive in spite of very real and valid credit concerns.

On the bank shutdowns front, the authorities had to shut down and clean up the largest carcass of this year yet on Friday when they decided to order the Colonial BancGroup to cease operations.

The experts that were discussing the Fed preparing to pare back their asset purchases supporting the credit markets turned out to be right.  The Fed left rates unchanged at their latest policy meeting, but they announced that they plan to wind up their Treasury Bond purchasing program by October.  While this is out of character with the Bernanke Fed, the negative impact on the bond market lasted less than 5 minutes.

NOTEWORTHY:  The economic calendar was mostly disappointing last week.  The week started off with a pair of little watched, but significant data points.  Productivity was up 6.4% in Q2 while Labour Costs declined a massive 5.8%.  All of the sudden the market action makes all the sense in the world: stocks are going to the moon as companies are able to increase productivity and slash labour costs at astronomical rates saving oodles of cash in the process.  No wonder this earnings season was all about better than expected earnings driven by costs being slashed at a faster rate than revenues are falling.  As labour costs are tanking, of course the consumer will have less money to spend - couple that with ongoing contraction in Consumer Credit and the outlook for the demand side looks pretty bleak.  On the other hand bonds are not going anywhere in spite of tanker loads of supply since aggregate demand is telling us that all we need to fear is fear itself on the inflation front.  So as long as companies are able to continue to increase productivity and in turn slash costs at a 5-6% clip indefinitely, we should expect stocks to continue to rally indefinitely as well.  Weekly Initial Jobless Claims increased marginally from 554k to 558k last week. 

The US Trade deficit increased $1 Billion to $27 Billion in June on mostly stronger energy import prices.  Retail Sales were about 1% lower than expected – both the headline and the ex-auto numbers showed a decline in spite of the wildly successful Cash-for-Clunkers program.  While Industrial Production increased for only the second time since the end of 2007, it still remains quite depressed and barely met expectations.  Consumer Inflation was flat in July.  A worrisome new trend is developing in Consumer Confidence.  It fell for the second month in a row after a feeble bounce in spite of expectations for a rise.  In Canada, the Trade Balance remained negative in spite of a significant boost from a 22% jump in energy exports.  This week’s schedule will be dominated by Housing Data and PPI.

INFLUENCES:  Trader sentiment surveys were essentially unchanged last week.  I expect sentiment to be somewhat supportive going forward as there is plenty of room before this metric becomes overdone.  The Commitment of Traders reports showed that Commercial traders were net long 441k 10 year Treasury Note futures equivalents – a slight increase of 11k from last week.  This is positive.  Seasonal influences are positive after mid-month.  The technical picture is neutral as bonds remain in a trading range.  I expect that we should get some follow through to higher prices in the long bond during the weeks ahead.

RATES:  The US Long Bond future rallied over 3 points to 118-25, while the yield on the US 10-year note declined 30 basis points to 3.56% last week.  The Canadian 10 year yield was 13 basis points lower at 3.48%.  The Canada-US 10 year spread decreased 17 basis points to 8.  The US yield curve was flatter as the difference between the 2 year and 10 year Treasury yield decreased 6 basis points to 250. 

BOTTOM LINE:  Bond yields reversed most of their sharp increases from the previous week, while the yield curve became slightly flatter.  The fundamental backdrop remains weak, which is supportive for bonds.  Trader sentiment is slightly bearish – which is somewhat supportive; Commitment of Traders positions are supportive and seasonal influences are bullish.  I recommend keeping the long bonds that were purchased back in June.

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

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