US Treasury Bonds Range Trade Around 4%

By: Levente_Mady

The Treasury market streaked to 3 positive weeks in a row even after higher than expected inflation data.

On the financial sector front, write-offs have now exceeded $500 Billion. Conservative estimates from established organizations such as the IMF are forecasting the final tab to be over a trillion dollars. Meanwhile more pessimistic forecasters such as Nouriel Roubini are looking for double that figure by the time it is all done. The take away from this story is that the write-offs are nowhere close to being finished. The flavour of the past week was auction rate securities.

A number of the leading banks and dealers have agreed to buy back billions of these securities to add to the inventory of impaired assets on their books. Capital requirements will be an ongoing issue in the financial sector. As long as they need to raise massive amounts of capital, financials will struggle to put in a long term bottom. On-going problems on this front are likely to support the bond market.

Short term rates lead the decline in yields globally again last week. The majority of commodity charts now look like blow-off tops. Bond markets world wide are starting to realize that inflation is a lagging indicator, so the high CPI and PPI readings are discounted as yesterday's news. While PPI is close to 10% at this time, I would not be surprised to see a negative sign in front of it 12 to 18 months from now. The credit crunch is still gaining momentum. In a recent survey over 80% of bank lending officers indicated that they plan to further tighten lending standards. The bond market has been in a trading range for the most part of this year with the 10 year Treasury note yield stuck around 4%.

While the Fed has eased aggressively over the past 12 months, their efforts to increase liquidity and get the Treasury to print boatloads of new money have failed miserably. They are pushing on a string. Staying safe in the short end of the Treasury market has been and continues to be the most stable investment out there. At the expense of repeating myself, I would like to reiterate that as time passes by I remain convinced that the Fed will not raise rates in the foreseeable future.

NOTEWORTHY: The economic data was disappointing on both the (lack of) growth and inflation fronts last week. The Trade Deficit shrank $3 Billion in June despite record high oil prices. Exports are still booming while import growth remains anemic. The Treasury budget deficit seems to set new records month after month. The latest projections are looking for the annual budget deficit to exceed $500 Billion this year and to trend toward the $1 Trillion mark during the next 4 years. Retail Sales decreased 0.1% in July as the auto sector continues to free fall into the abyss. Business Inventories increased a higher than expected 0.7% in June confirming weak demand on all fronts. Meanwhile CPI increased by 0.8% after a 1.1% jump in June. The forecast was for a 0.3% increase. In spite of the elevated inflation readings, bonds managed to rally further as concerns of economic weakness trump inflation fears at this juncture.

Weekly Jobless Claims declined 10k last week to 450k. This is the third week in a row where claims remained at this new higher plateau after spending most of the past 5 years below the 400k threshold. That is terrible news on the employment front. I expect claims to be averaging over 500k per week before year end. Capacity Utilization increased from a downward revised 78.8% to 79.8% while Industrial Production increased 0.2% in July. The Michigan Consumer Sentiment survey (not exactly) gapped up 0.5% to a still depressing level of 61.7. This metric remains within a handful of points from the all time lows as sentiment is buoyed by declining gasoline prices for the time being. Next week's headliners will include housing data in the form of Building Permits and Housing Starts as PPI, Leading Economic Indicators and the Philly Fed's survey on the state of manufacturing in that neck of the woods.

INFLUENCES: Trader surveys remained neutral on bonds during the latest week. Bullish sentiment ticked back up a couple of points last week. The Commitment of Traders reports showed that Commercial traders were net long 314k 10 year Treasury Note futures equivalents – a decrease of 117k from last week. This is slightly supportive for bonds. Seasonals are positive for the rest of the month. As expected, the 10 year note yield continues to hover around 4%. My view is neutral; I expect more sideways action around 4% on 10 years. I hope to get a bit of a pull-back in prices in order to add to existing long positions in the short end.

RATES: The US Long Bond future traded up another point to close at 117-16, while the yield on the US 10-year note dropped 10 basis points to 3.83%. The yield curve was essentially unchanged 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 2 basis points to 145 last week.

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

BOTTOM LINE: Bond yields dropped lower, while the yield curve was unchanged last week. The fundamental backdrop remains bleak. Trader sentiment is neutral but COT positions as well as seasonal influences are supportive. The recommendation is to stay with the curve steepener, and continue to shun the weaker corporate credits. My bond market indicators are dead neutral, so I am looking for the market to stay in a range around the 4% yield level on the 10 year Treasury Note until further notice.

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

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