US Treasury Bonds Trend Higher Despite Inflation as Economy Continues to Weaken

By: Levente_Mady

The Treasury market extended its incredible winning streak to 3 weeks in a row! The trend remained intact as bonds continue to strangely trade higher with increasing energy prices. There was no relief for the financial sector as the US stock market started the second half the same way it finished the first half: round the bowl and down the hole… Credit spreads remain under pressure and liquidity is not improving. In spite of crude oil continuing to set new highs week after week, energy stocks are diverging noticeably. The lack of M&A activity even in the sector is just another sign of how severely liquidity has gone missing.

Last week the focus was on the FOMC as they left the Fed Funds rate unchanged, surprising nobody with that course of action. This week it was the European Central Bank's turn to have a meeting. They sounded quite adamant about raising rates to fight inflation prior to their shindig. So it was no big surprise that for the first time in 2 years the ECB raised their benchmark lending rate 25 basis points to 4.25%. The surprise came at the post-meeting press conference, where ECB Chief JC Trichet indicated that the Bank has adopted a neutral bias. While I would like to give credit to the ECB leadership for actually stepping up and backing up their saber rattling with a rate hike, in the big scheme of things one 25 basis point rate hike ain't exactly gonna kill inflation dead. However the major slowdown that is transpiring in the world economy should do the trick. The bond market trades like it expects this. The shorter maturities of the yield curve remained well supported. I am standing by 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.

NOTEWORTHY: The economic data remained on the weak side again last week. Auto Sales plunged again in June as higher gasoline prices combined with a bleak outlook for the job market took their toll. While in 2005 over 17 million new light vehicles were sold, the latest figure stands at 13.6 million and dropping. In spite of an analyst at a major US brokerage warning of a real danger of GM going bankrupt, I expect new auto sales to drop under 10 million within the next 3 years. Construction Spending declined 0.4% in May. The ISM indexes were mixed and the headline numbers masked some underlying weakness. The price components of both the Manufacturing and the Services index were highest ever (at 91.5 and 84.5 respectively), providing a misleading lift of the overall number.

Even so the Manufacturing index was stuck at 50.2 and the Services index headline figure fell like a rock from 51.7 to 48.2, indicating that the services sector is expected to contract during the next 6 months. The Employment components on both surveys dropped 2-5 points. They are both below 44 and pointing to further weakness on the labour front. Weekly Jobless Claims increased 16k to 404k last week. The Unemployment rate paused its increasing trend after a .5% jump to 5.5% last month. Non-farm payrolls decreased 62k and more importantly previous months' payrolls were revised down to the tune of 52k. It would be a huge challenge to find a silver lining in any of the above labour market data. Next week's headliners will include Consumer Credit, the Trade (Im) Balance, the Michigan (lack of) Consumer Confidence Survey. Most of these data points are considered to be second tier, so they should have a muted effect on the market.

INFLUENCES: Trader surveys remain in neutral on bonds during the latest week. As expected when the market rallies, the levels have started moving up toward bullish territory. No COT data this week yet due to the July 4 holiday in America . Last week's 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 are turning negative as we get past the first couple of trading days in July. After trading up to 4.30% 3 weeks ago, the 10 year note yield settled back under 4% for the second week running. The positive factors are diminishing; an increase on the 10 year yield above 4% would tilt the bias to bearish on the technical front also. I got the weaker than expected employment report that I was looking for (see above for details), but the lack of positive follow through in the long end of the market leads me to believe that the upside is limited in the long bond near term.

RATES: The US Long Bond future traded up a quarter of a point to close at 115-28, while the yield on the US 10-year note was unchanged at 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 10 basis points to 144 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 again last week. The fundamental backdrop remains bleak. Trader sentiment is neutral, while COT positions are quite supportive but seasonal influences have changed to negative. The recommendation is to stay with the curve steepener, and continue to shun the weaker corporate credits. My bond market indicators dropped slightly but they remain in positive territory, so I am looking for the market to settle into a range around the 4% yield level on the 10 year.

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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© 2008 Levente Mady, All Rights Reserved

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