U.S. Treasury Bonds Blow-off Top?

By: Levente_Mady

The bond market just keeps on chugging higher. Yields on the 30 year Treasury Bond decreased for a 6 th consecutive weeks as the Long Bond future rallied an unprecedented 23 points since the end of October. If it looks like a duck, walks like a duck and quacks like a duck, then it must be just another blow-off top. It is really no big deal, blow-offs have been a dime a dozen this year, so there is no reason to get too excited.

Heading into the year end, the signs of extreme distress remain evident in the bond market. Treasury yields are falling to extreme lows, in some cases to negative yields as investors seek the “safety” of US government guaranteed product. At the same time, credits that are perceived weaker – even ones that are pretty much fully guaranteed by that same US government – remain under pressure as yield spreads continue to expand. I am not sure where this trend will end, but I am quite sure that it makes absolutely no sense under the theory of “efficient markets”. It could be argued that all the financial bonds of the “too big to fail” entities, should be trading ever so slightly above Treasury bonds in terms of yield, due to a liquidity premium. That is not the case.

A couple of weeks ago I mentioned a Goldman Sachs issue that was trading at a massive premium to 3 year Treasuries. This week's example comes from the Canadian market. The Canadian banks have supposedly weathered this financial storm in much better shape than their international counterparts. However, it does not mean that they don't need capital in a big way. They have been issuing common shares, preferred shares and bonds like there is no tomorrow. The Bank of Montreal issued some 10 year bonds last week with at 10.22% yield. That is a cool 220% (700 basis points) over the 10 year Canada bond. It is just not very efficient!

On the Central Bank activity front, last week it was the Bank of Canada's turn to slash its overnight policy rate by 75 basis points to 1.5%, while the US Federal Reserve is expected to halve its key rate next week to 0.50%. With Treasury Bills trading at 0 or even negative yields, it hardly matters what the Fed Funds rate is these days.

NOTEWORTHY: The economic calendar actually had some positive surprises last week. The latest numbers were still quite bleak; they were just a touch better than dismal expectations. Pending Home Sales declined 0.7%, but they dropped considerably less than the September fall of 4.3%. Wholesale Inventories were down 1.1%. The US Trade deficit refuses to decline even with plunging energy import prices. While both exports and imports have been on the decline since July, exports are falling faster, keeping the deficit stable around the $55-60Billion mark and underlining the global nature of the present economic woes. Weekly Jobless Claims exploded from 515k to 573k last week, while Continuing Claims jumped from 4.09 Million to 4.429 Million for the latest survey week.

The Claims figures were substantially worse than expectations. The Producer Price Index declined 2.2% - in line with expectations. The most significant data item last week was the Retail Sales report. Sales declined 1.8% in November, which was slightly less than consensus at -2%. The Michigan Consumer Sentiment survey rose 4 points to 59.1. The Canadian economy is teetering on the edge, but has not fallen off a cliff as yet. Auto Sales are holding up remarkably well, but Housing Starts declined close to 20% in November as Prices are starting to cave in. The Canadian Trade Surplus is at a respectable$3.8Billion, but Labour Productivity is declining at a 1.2% clip over the past year and Capacity Utilization declined 0.3% during Q3. Next week's schedule in the US will be highlighted by the Consumer Price Index and Housing Sector reports.

INFLUENCES: Trader surveys are more excessively bullish than last week. This is a strong negative. The Commitment of Traders reports showed that Commercial traders were net long 316k 10 year Treasury Note futures equivalents – an decrease of 4k from last week. This is slightly positive for bonds. Seasonal influences are positive for most of December. The bond market is heavily overbought. The 10 Year Note came within a whisker of 2.5%, while the 30 Year Bond yield traded below 3%.

If we are not at or within a stone's throw of an intermediate top, then it might be time for me to switch to bird watching instead of bond market forecasting. Please note the key word: intermediate! One item I would like to see in order to turn wildly bearish: the COT data to show commercials switching from a large long to a short position on the Long Bond contract. Heading into year end could be quite treacherous for both bulls and bears. We saw signs of excessive volatility last week with hardly a reason for it and year-end flows could easily exacerbate this situation.

RATES: The US Long Bond future traded up another 1 and a half points to close at 134-26 last week, while the yield on the US 10-year note decreased another 13 basis points to 2.57%. The yield curve was stable as the difference between the 2 year and 10 year Treasury yield was 181 basis points, which represents a slight steepening of 3 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 relatively stable last week. The fundamental backdrop remains pathetic, which is supportive for bonds. Trader sentiment is now overly bullish, Commitment of Traders positions are slightly supportive and seasonal influences are positive. The market is way overbought. My bond market view is negative at this point.

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

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