US Treasury Bonds Rally Continues as Fannie and Freddie Nationalized

By: Levente_Mady

The US Treasury market has been stair-stepping higher since the middle of July. The US Long bond was within a whisker of its annual high on Friday immediately following the weaker than expected employment report. Canadian bonds also rallied in spite of disappointment with latest policy directives from the Bank of Canada.

Fannie and Freddie were back in the headlines last week as they were at least partially responsible for the bond market rally. The news on the weekend is that the US government is taking over these basket cases. It looks like the market liked the bail-out so much that the stock of those companies declined about 25% in after hours trading. Just leave it to the government to fix things! The question remains: what next? We had hordes of analysts analyzing the situation and estimating the losses, and crunching the numbers and trying to forecast how much the bail out will cost and how many more banks will be shut down (the count in the US just rose to 11 as Silver State of Nevada closed down this weekend) and all.

What I find peculiar is that I just don't see much material about the impact on the average guy – the typical US Consumer: the gal who lives on cash-flow, the guy who is up to his eyeballs in debt, the parent who just lost his job. Is it going to be easier again for those folks to get a mortgage with no docs, no money down and 0% interest rates for 125% of the property value? Is the worst is behind us? Is it all back to normal – whatever normal may be? The way I read the headlines, it tells me that the government felt it had to step in and take control of Fannie Mae and Freddie Mac in order to save the mortgage boat from capsizing. It sounds like the plan is to reduce the government exposure in the mortgage market ASAP with the lowest cost imaginable. The details remain to be seen as yet, but it does not sound like the mortgage tap will be reopened indiscriminately to try to re-inflate the housing sector at all cost.

The Treasury and the US government took the first steps to bail out Fannie and Freddie this weekend, but I don't expect everything to return to “normal” as a result starting next week. The economy will continue to weaken and the Fed will not raise rates any time soon. On the contrary, I will stick with my forecast that the Fed and the Bank of Canada will be easing in the not too distant future. On the other hand, the bail out will increase the supply of Treasury bonds significantly, which in turn should pressure Treasury yields higher in the short run.

NOTEWORTHY: The economic data was disappointing last week. Let's see! Construction Spending declined 0.6% in July. The ISM Manufacturing Survey held steady at 49.9. Not that it matters since nobody makes nothing in America no more. It all comes from the BRIC countries. ISM Services was reported at 50.6. As long as the consumer keeps spending, ISM Services will likely hang around the 50 level. Wee kly Jobless Claims increased 15k last week to 444k. The monthly Employment report was another unmitigated disaster. Non-farm Payrolls declined another 84k. The previous months' figures were revised down another 50k on top of that. The Unemployment Rate jumped from 5.7% to 6.1% and it is up close to 40% from the cycle low of 4.4%. The data was all substantially weaker than forecasts.

The momentum is toward more weakness in the US labour market. The Canadian Employment report was much better than the US data. The Canadian economy created 15k new jobs in August, which was encouraging after the massive loss of 55k reported in July. I am expecting more weakness on the Canadian labour scene as well. The Bank of Canada left its overnight rate unchanged at its policy meeting last Wednesday. The bond market was clearly disappointed with the decision and the lack of hints of a rate cut in the near future. Canadian bond market players have to look all the way out past 5 years on the Canada bond yield curve to find a return higher than the present 3% overnight rate. The market is screaming for a Bank of Canada rate cut. Soon the Bank will wilt under the pressure. Next week's reports will include Consumer Credit, Trade Deficit, Retail Sales and the Michigan Consumer Sentiment survey.

INFLUENCES: Trader surveys ticked up into slightly overbought levels on bonds during the latest week. The Commitment of Traders reports showed that Commercial traders were net long 200k 10 year Treasury Note futures equivalents – an decrease of 11k from last week. This is now neutral for bonds. The seasonal influences are neutral for the rest of September. The 10 year note yield plunged close to 3.50% before adjusting back to 3.70%. My view is negative; I expect the 10 year note yield to head back up toward 4%.

RATES: The US Long Bond future traded up almost 2 points to close at 119-02, while the yield on the US 10-year note decreased 11 basis points to 3.70%. The yield curve was flatter but I am retaining my steepening bias just a little longer. 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 decreased 4 basis points to 140 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 continues to deteriorate. Trader sentiment is leaning bearish while COT positions as well as seasonal influences are neutral. The recommendation is to invest in the 2 year Treasury and Canada bonds, and to shun the weaker corporate credits. I am expecting the 10 year Treasury Note yield to drift back up toward 4%.

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

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