Bond Yields Breakout to New Multi-year Lows

By: Levente_Mady

The bond market convincingly broke out to new multi decade lows on yields. As the dismal economic data just continues to get worse, Treasury securities ironically remain the safe haven of last resort. Once the Quarterly Treasury auctions were out of the way, traders got the green light to boldly take the US Long Bond Futures to levels where no Long Bond contract has gone before! Risk remains the dirtiest of all dirty four letter words, so government bonds are the best place to hide.

I was asked by a TV reporter last week how it was possible for the hundreds of economists employed by the US Federal Reserve to misjudge this financial and economic storm that we find ourselves in at the moment. After some consideration, I came up with the following key points. 1, If I was an aspiring economist who had to chose between going to work for the Fed and get paid $50k a year or Goldman Sachs and get paid the same $50k per month instead – call me greedy and short sighted – but I would take the Goldman job without blinking an eye.

The point is that quality is more important than quantity, except when it comes to your pay scale. 2, Can anyone imagine a Fed (or other Central Bank representative) come out during good times and sow panic by declaring that the economy is about to blow up as we are faced with a credit bubble that is spiraling out of control? The job of the Central Bankers is to pay lip service to fighting inflation and acting as a lender of last resort to anchor the financial system. As we found out last week, inflation is quickly becoming a non-issue and Central Banks certainly have had their hands full with their ever expanding activities as lenders of last resort.

And while on the topics of economics and Goldman Sachs, have you all seen the latest economic forecast from the still well compensated folks at Goldman Sachs? They – along with just about everyone else – were busy taking the machete to their outlook again. GS is now looking for the US economy to decline 5% in Q4 2008, 3% in Q1 of 2009 and 1% during Q2 – 2009. That is growth rates (for those of you who prefer the “g” word) of -5, -3 and -1% for the 3 quarters starting with the present one. Yes, indeed, those are the same leading lights of Wall Street who managed to downgrade Lehman Brothers from a BUY to a HOLD (not REDUCE or SELL) 2 days before Lehman went bankrupt! Needless to say, the armies of Fed economists are still doggedly stuck to forecasting flat to 1% growth for 2009. I would say that is somewhat overly optimistic still in my humble opinion.

NOTEWORTHY: Just when it was hard to imagine that it could get any worse, the economic calendar became even bleaker last week. Retail Sales declined a massive 2.8% in October. This is the 4th month in a row of accelerating declines in this key data series. One of the main reasons why Retail Sales are plunging is because people are losing their jobs. Wee kly Jobless Claims skyrocketed from 484k to 516k to 542k during the past 2 weeks, while Continuing Claims topped the 4Million level for the first time in decades. The inflation metrics are also plunging and partially responsible for aiding the bond market rally. The Producer Price Index fell 2.8% in October, while the year over year figure was pretty much cut in half during the past three months to 5.2% and falling.

The landscape is similar on Consumer Prices. They plunged 1% in October and the annual rate declined from a recent high of 5.5% to 3.7% for the latest period. The housing sector remains in the doldrums as activity declines and the outlook that is measured by the Home Builders' survey continues to set new all time lows. Leading Economic Indicators are leading to a lower outlook as they are now forecasting a near 4% decline in economic activity going forward. Next week's schedule in the US will be highlighted by the second cut at the Q3 GDP report, more housing data in the form of New and Existing Home Sales, Durable Goods Orders, Personal Income and Spending data as well as a fresh set of (lack of) Consumer Confidence Surveys.

INFLUENCES: Trader surveys are bullish. This presents a headwind for bonds. The Commitment of Traders reports showed that Commercial traders were net long 305k 10 year Treasury Note futures equivalents – a decrease of 36k from 2 weeks ago. This is slightly positive for bonds. Seasonal influences are negative during the last week of November before turning positive for the rest of the year after this week. The view becomes more negative for bonds.

RATES: The US Long Bond future traded up 10 points to close at 126-10 during the past 2 weeks, while the yield on the US 10-year note decreased 59 basis points to 3.20%. The yield curve flattened considerably during the same time frame. This spread was at 247 2 weeks ago not at 267 as I mistakenly reported it. The difference between the 2 year and 10 year Treasury yield was 210 basis points as of Friday, the 21 st , which represents a flattening of 37 basis points. As short term yields get closer to zero, the shape of the yield curve is driven by the dynamics in long term rates.

BOTTOM LINE: Bond yields declined across the spectrum, while the yield curve was flatter due to a sharp drop in long term yields during the last 2 weeks. The fundamental backdrop is just getting worse, which is supportive for bonds. Trader sentiment is becoming overly bullish, Commitment of Traders positions are slightly supportive and seasonal influences are negative. With the short Thanksgiving holiday on tap trading could continue to be volatile. My bond market view is negative at this point.

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

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