Rising Bond Yields Despite Interest Rate Cuts

By: Levente_Mady

The bond market traded sharply lower last week despite the ever intensifying turmoil in world financial markets. The Treasury decided to auction a special $40 Billion 10 year Notes to ease the demand for Treasury paper in the bond market. So all of the sudden it appears that in spite of the safe haven qualities of US Treasury Bonds and Bills, the market has realized that with all the government bailouts and guarantees, there will be no shortage of government bonds going forward.

So while the banking system could continue to come unglued, further unscheduled new Treasury supply could knock yields higher again. But that seems to be a minor issue at the moment. The big deal at this point is not the price of credit (as manifested by interest rates) but the AVAILABILITY of credit. There was enough going on last week to write a book about – and I am sure many books will be written about it – but here are some of the highlights…

The chatter about Central Bank rate cuts has morphed into action last week. The market was looking for imminent rate cuts from the Fed, and other Central Banks and they certainly obliged. On Wednesday morning, October 8, the Federal Reserve Bank of the US cut rates by 50 basis points to 1.50%, with the Bank of England, Canada , Sweden as well as the European Central Bank joining the rate cut party. A number of other Central Banks cut their rates last week as well. Unfortunately this decisive and coordinated effort did not have the desired impact as credit markets remained frozen and stocks continued to crater for the rest of the week.

So the CONTAGION has now fully spread to the stock market. The other sector of the market that has experienced massive volatility is the foreign exchange trading. Believe it or not, the foreign exchange moves have also been driven by interest rates. The high interest paying currencies – such as the Icelandic Krona, Australian Dollar and the Mexican Peso - have been annihilated, while low yielders such as the Japanese Yen and the US Dollar were the beneficiaries of the recent financial flows.

NOTEWORTHY: The economic calendar was fairly light. For the first time in years, Consumer Credit declined in August. It was down $7.9 Billion, with the bulk ($7.6B) of the decline coming from non-revolving credit. This metric is considered minor, but I pay close attention to it as a barometer of consumer mood and health. While one data point a trend does not make, annual Consumer Credit growth has slowed from 6% to 3.3% over the past 6 months. Stay tuned for more on this key metric. Wee kly Jobless Claims fell 20k last week to 478k, but it remains at elevated levels. The US Trade deficit declined from $61.3 Billion to $59.1 Billion in August as both imports and exports fell. This is relatively outdated information, and further declines can be expected on all fronts in this space.

The Canadian Trade surplus on the other hand soared from $4.2B to $5.8B. I wonder if that is why our Canadian $ is down to .85 Cents US? I would say that this is just another example of fundamentals just do not matter when panic rules the markets. The Monthly Employment report in Canada showed a rip-roaring increase of 107k jobs, while the official Unemployment Rate managed to stay unchanged at 6.1% due to more people joining the workforce. Even though 97k of the new jobs created was of the part time variety, this report was stellar nevertheless. Next week's schedule will be highlighted by inflation data as well as reports on Retail Sales, Housing Starts, Industrial Production and various business and consumer sentiment surveys.

INFLUENCES: Trader surveys are back at neutral levels on bonds, as they have moderated over the past weeks. There is a strange divergence in sentiment as the futures trading crowd remains excessively bullish, while the mainstream (cash investor) advisors are now leaning slightly bearish in their views. The Commitment of Traders reports showed that Commercial traders were net long 372k 10 year Treasury Note futures equivalents – an increase of 16k from last week. This is somewhat positive for bonds. Seasonal influences on the other hand are negative here. The 10 year Treasury Note yield rose sharply even as market turmoil increased the appeal of Treasury securities. My view remains slightly negative; I expect the 10 year note yield to test 4% in the coming week or two.

RATES: In spite of the world wide financial turmoil, the US Long Bond future traded down 3 points to close at 116-20, while the yield on the US 10-year note increased 27 basis points to 3.87%. The yield curve was steeper and I am retaining my 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. This spread increased 22 basis points to 224 last week.

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

BOTTOM LINE: Bond yields jumped sharply, while the yield curve was steeper again last week. The fundamental backdrop is a disaster, which is supportive for bonds. Trader sentiment is neutral, Commitment of Traders positions are slightly supportive, but seasonal influences are quite negative. 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

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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