U.S. Treasury Bond Market Enters 2009 Trading Range

By: Levente_Mady

The bond market appears to be settling down into a trading range after the sharp rally during the last 2 months of 2008. The Long Bond essentially recovered the losses from the previous week. The financial sector continues to unravel and the effects are translating into massive problems for the global economy.

On the Central Bank front, last week it was the European Central Bank's turn to lower its key lending rate from 2.5 to 2% and next week it will be the Bank of Canada that will most likely cut its benchmark rate from 1.5 to 1% on Tuesday. We expect Central Banks to continue in easing mode for the foreseeable future.

Incredible as it may seem, the woes in the financial sector just continue to multiply. While 2 more small banks were shut down by the authorities in the US over the weekend, global financial leaders Citibank and Bank of America were in the headlines for the wrong reasons. Citi shares are trading well under 5$ while BofA are not far above that level. While Citi is wallowing in a mess of its own creation, Bank of America is feeling the pain of another $15Billion loss announced by its recently acquired Merrill Lynch subsidiary. Both of these institutions are in the “too big to fail” category, so while common share holders are likely to lose all their investment in these darlings, depositors and bond holders should enjoy some form of a government guarantee for their stakes in this space. In spite of the ongoing problems on the financial front, continuing weakness on the economic scene and the nervousness in the market heading into the meat and potatoes of the earnings season, the long end of the bond market did not trade particularly well since the beginning of the year.

It is no big surprise that the front end of the yield curve in the US (0 to 3 month maturities) remains anchored at 0%. Certainly the financial sector needs a steeper yield curve to aid its recovery, but that steepener is not quite happening, which enforces my view that (not just the US but the world) economic activity is far and away from picking up steam. On the other hand, the authorities continue to insist that the best way to solve the crisis caused by too much credit and leverage should be solved by encouraging more borrowing and less saving. As long as interest rates are at or near zero, there is no motivation to save since savers do not get any return on their capital. At the same time, anyone who is deemed to be credit worthy can borrow at ultra low rates. The immediate goals are clear; how we get there and what the implications will be further down the road are much more muddier!

NOTEWORTHY: The economic calendar was busy last week. The US Trade Deficit shrank by about 30% to $40Billion as both imports and exports tumbled. Retail Sales declined 2.7% in December and they are down close to 8% in 2008. Inflation is collapsing both on the Producer and Consumer fronts. While a number of the headline readings have been in negative territory for months now, the Core components of the inflation indexes remain in positive territory for the year over year figures. Weekly Jobless Claims jumped 54k to 524k over the past week, correcting the declines seen over the holidays. Industrial Production fell 2% in December while the year over year activity is off over 8%.

Capacity Utilization also remained under pressure declining 1.6 points to 73.6%. The Philadelphia Fed Manufacturing Index jumped 12 points to -24 while the Michigan Consumer Sentiment Index moved up 2 points to 62 (100 is neutral). The Canadian economic calendar was sparse. Our Trade Surplus shrank to an 11 year low of $1.3 Billion in November. Next week's schedule will be extremely quiet as Monday is a holiday and Tuesday will be the inauguration day for Mr. Obama, the new US President. The only report of note will be the Building Permits and Housing Starts data scheduled to be released Thursday morning.

INFLUENCES: Trader surveys tempered their bullish bias but remained optimistic than last week. This is a slight negative. The Commitment of Traders reports showed that Commercial traders were net long 288k 10 year Treasury Note futures equivalents – essentially unchanged from a week ago. This is slightly positive for bonds. 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 started paring back but they are still long. Seasonal influences are neutral this week. The technical picture is damaged, so I don't expect the Long Bond future to recover to the highs over 140. On the other hand, I am not forecasting a sharp sell-off either. That leaves us with a trading range: 130-140 on the bond future, 2-2.6% on the 10 year note. My bias is slightly negative, especially after the first week of trading in February.

RATES: The US Long Bond future traded up 3 points to close at 136-07 last week, while the yield on the US 10-year note fell 8 basis points to 2.32%. The Canadian 10 year yield fell 17 basis points to 3.63. The US yield curve was stable as the difference between the 2 year and 10 year Treasury yield moved to 160 basis points, which is a flattening of 3 bps.

BOTTOM LINE: Bond yields drifted slightly lower, while the yield curve was pretty much unchanged last week. The fundamental backdrop remains pathetic, which is supportive for bonds. Trader sentiment is bullish – which is negative, Commitment of Traders positions are slightly supportive and seasonal influences are neutral. The market has started a corrective phase. My bond market view is slightly negative at this point.

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

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