Grossly Overbought Bond Markets Continue Chugging Higher into New Year

By: Levente_Mady

The bond market just keeps on chugging higher. Yields on the 30 year Treasury Bond decreased for an 8th consecutive week as the Long Bond future continues its unstoppable march higher. There are a couple of undercurrents that I would like to discuss heading into the New Year.

Once the year end shenanigans are out of the way, I expect that the very short end (0-6 month) of the yield curve will loosen up somewhat and stop trading at 0% or negative yields. The quality spreads (Libor vs. Bills, Eurodollars vs. Bills, OIS) in the short end have been creeping in, but they are still far from normal. I expect this trend toward tighter spreads to continue in the New Year. The tricky part is what will happen to the long end. The market had a massive rally and it is ridiculously overbought. On the bullish side of the ledger we have a deflationary threat that could take long term yields down to sub 1% on a nominal basis even as real yields rise as a result of rising deflation.

Couple this with plans at the Fed to buy long term bonds to support the Treasury market and the fact that Smart Money Commercial traders have record long exposure to the Long Bond futures. On the bearish side of the ledger, year end flight to quality buying will stop in 2 days at the most; technical indicators and trader surveys are incomparably overbought; precious metals are showing some signs of bullish action; there are 3 and 10 year bond auctions scheduled for the week after next and fundamental expectations are now so dismal that weak data can still beat those expectations and cause some pain for bonds.

In addition to the Eurodollar vs Bill spread, corporate bond spreads (including junk) appear to be settling down here as well. That is a sign of some liquidity returning. The terrible news (in addition to the continuing deterioration of the fundamental landscape) is the fact that the yield curve is flattening like crazy. The 2-10 year spread has been cut in half since the end of October to 125. The multi-decade average on this puppy is around 75 basis points. If we dip below that, it will just tell me that NOTHING of the ALL OUT WAR ON DEFLATION lead by the Fed is working. The shape of the yield curve is one of the best leading indicators of economic activity. In October the yield curve forecasted a decent chance of a bounce in economic activity in 2009. That chance has been quickly diminishing since then. If long term yields stay here or head toward Japan- like 1% levels, it would simply mean that in spite of its best efforts the Fed is losing the battle against deflation.

NOTEWORTHY: The economic calendar did not provide much Christmas cheer last week. The final release of the Q3 GDP was reported as a 0.5% decline, which was unchanged from the first revision. However, the surprise came on a downward revision of the Deflator (the inflation component) from 4.2 to 3.9%. This means that nominal GDP was revised down from 3.7 to 3.4%, which means further weakness. There was more bad news for the housing sector. Both Existing and New Home Sales declined again to new multi decade lows as inventories remain sky high and price declines continue to accelerate. The Michigan Consumer Sentiment remained stable at significantly depressed levels. Wee kly Jobless Claims jumped to their highest level in decades as they increased 30k to 586k last week.

Personal Income declined 0.2% in November while Personal Spending dropped 0.6% during the same period. The Canadian economy is teetering on the edge, but has not fallen off a cliff as yet. Canadian GDP for the month of September was up 0.1% after a 0.5% decline in August. Next week's schedule in the US will be highlighted by the Consumer Confidence and the ISM Manufacturing surveys in a quiet week before the ball gets rolling in the new year.

INFLUENCES: Trader surveys are more excessively bullish than last week. This is a strong negative. There was no new survey for the Commitment of Traders due to the Christmas break. The Commitment of Traders reports showed that Commercial traders were net long 391k 10 year Treasury Note futures equivalents the previous survey week. This is somewhat positive for bonds. Seasonal influences are positive for most of December. The bond market is ridiculously overbought. The 10 Year Note is knocking on the 2% door, while the 30 Year Bond yield traded below 2.5%.

One item I would still 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. They have shown no interest whatsoever in heading for the exit yet. Heading into year end could be quite treacherous for both bulls and bears. Next week is difficult to forecast as illiquid conditions will persist, but I expect the following week to see at least a 5-6$ correction in the Long Bond future.

RATES: The US Long Bond future traded up another half point to close at 141-55 last week, while the yield on the US 10-year note was pretty much unchanged at 2.13%. The yield curve continues to flattene as the difference between the 2 year and 10 year Treasury yield was 125 basis points, which represents a flattening of 13 bps. As short term yields are at zero, the shape of the yield curve is driven by dynamics in long rates.

BOTTOM LINE: Bond yields were stable in spotty holiday trading, while the yield curve was flatter again last week. The fundamental backdrop remains pathetic, which is supportive for bonds. Trader sentiment is now exceedingly bullish, Commitment of Traders positions are slightly supportive and seasonal influences are positive. The market remains grossly overbought. My bond market view is negative at this point.

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

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