Inflation Sends US Treasuries Sharply Lower

By: Levente_Mady

The Treasury market sold off sharply last week. Ongoing weakness on the economic front is taking a back seat to other issues as the 10 year yield broke through the significant 4% barrier. The inflation chatter we discussed last week continued to stay front and center not only in the US but across the globe also as energy prices remained sky high. A key event last week was the poor interest in the Treasury Note auctions that were conducted on Wednesday and Thursday. Both the 2 Year and the 5 Year auctions were met with lousy domestic interest and more importantly a significantly diminished foreign Central Bank sponsorship.

Treasury and Fed officials must be holding their breath hoping that this is just an aberration and not the start of a new trend. Declining official foreign buying of Treasuries in conjunction with an increasing supply has the potential to significantly increase not only US Treasury market yields but also rates on other US Dollar denominated fixed income assets as well. Higher interest rates and skyrocketing energy costs are not the ideal ingredients for an economic recovery. In spite of the inflation fighting rhetoric from the like of Dallas Fed President Fisher, I just can't imagine the Fed raising rates any time soon while under the fearless leadership of Helicopter Ben. Interest rates set the tone, and with the financial sector still deteriorating my 2 favourite trades are 1, buy bonds - sell stocks and 2, buy short term bonds - sell long term bonds, i.e. the yield curve steepening trade.

Last week I discussed briefly where REAL real yields might be. Obviously at below -5% no sane investor should be buying Treasury bonds. But somehow lots of investors are buying Treasuries and as a result severely penalizing savers while handsomely rewarding consumers and borrowers in the process. It is pretty obvious that the US officialdom has a huge ax to grind in order to lower their borrowing costs as much as they can get away with. And funnily they are getting away with officially zero and unofficially lower than -5% real interest rates when the historic norm should be more like 1-3% as one moves out the maturity spectrum.

Some people have even suggested that due to the declining quality and increasing supply of Treasury Notes those rates should even be higher. As Big Cheese Bob Hoye pointed out to me last week, historically real rates tended to bottom out around the -5 to -7% level and when they started to increase back to more reasonable levels usually things got real ugly in the real economy. So while there is some debate as to what the measured inflation should be, the bottom line is that regardless of the reference point, if real rates explode, chances are that a few things might start imploding at the same time. Keep an eye on real rates for a sign of things to come…

NOTEWORTHY: The economic data calendar was mostly as expected in the US last week. Consumer Confidence remains at or near multi-decade lows. New Home Sales actually rose about 3% in April, mostly because the March figure was revised down about the same amount. We are looking for further downward revisions. Durable Goods Orders declined 0.5%, but that is OK as it was mostly the volatile transport component that was responsible for the decline. Huh??? Wee kly Jobless Claims increased 4k to 372k last week. First time in a long time Personal Income kept pace with Spending as they were both flat in real terms. The consumer has not given up spending yet, so watch for more weakness on this front. Preliminary Q1 GDP in the US was revised up from 0.6 to 0.9%. No official recession in the US as of the first quarter. No such luck in Canada .

Pundits have been telling us that Canada is different this time due to our resource based economy. I for one and the Bank of Canada for another certainly did not seem to think so. The Canadian Q1 GDP figure was reported at -0.3% last week. So the latest figures are actually telling us that Canada might hit an official recession before the US will. Go figure! Next week's headliners will include the usual slew of first week figures such as the ISM Surveys and the Employment report.

INFLUENCES: Trader surveys have trended down for the past month and remain in neutral territory on bonds during the latest week. The Commitment of Traders reports showed that Commercial traders were net long 281k 10 year Treasury Note futures equivalents – an increase of 99k. The COT data is neutral with a slight positive bias. Seasonals are positive. The 10 year yield broke through support in the 3.9 to 4% area. The positive factors are dominant, but the market is breaking down. The technical picture is negative.

RATES: The US Long Bond future traded down over 2 points to close at 114-15, while the yield on the US 10-year note increased 21 basis points to 4.05%. The yield curve was stable but 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 1 basis point to 142 during the past week. It looks like the curve steepener has run into solid resistance at the 200 level. This may take months to overcome. In the mean time the range is expected to be 140 to 200.

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

BOTTOM LINE: Bond yields increased substantially last week, breaking some key levels in the process. The fundamental backdrop remains bleak. Trader sentiment and COT positions are neutral, while seasonal influences are supportive. My recommendation is to stay with the curve steepener, and continue to shun the weaker corporate credits. 4% was broken on the 10 Year; it is time to stand aside from our bullish bias.

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

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