U.S. Bond View Positive Despite Higher than Expected Inflation

By: Levente_Mady

The bond market traded higher last week. The fundamental data remains weak and pressure on the stock markets lent renewed support for bonds. Supply remains a topic of conversation for traders as the Treasury will be auctioning close to a total of another $100 Billion 2, 5 and 7 Year Notes next week. If interest remains as solid as it was on the Quarterly refunding last week, then bonds should manage to continue to hold the support levels that were tested and held during the recent down-trade.

There a few items that I watch for clues of where rates are heading. In the long run the fundamentals tend to win out, but that does not mean that in the short run we may not see what may be considered “irrational behaviour by some market watchers. The fundamental picture looks dismal not only in the US but even more so globally. What is most discouraging is that the majority of data still tends to be below consensus expectations. While there is a great deal of media focus on the massive supply of Treasury bills, notes and bonds that will continue to be an increasing part of the bond market landscape, historically the fundamental factors tended to outweigh the supply concerns. It is a historical fact that during slowdowns in the economic cycle fiscal budgets tended to deteriorate as governments have resorted to fiscal stimulus to kick start the economy while tax receipts fell to exacerbate the deterioration on the fiscal balance front.

At the same time however as output gaps opened up increasing slack in the economy, inflation tended to decline significantly during economic contractions. This allowed not only Central Banks but also markets to lower interest rates in short as well as intermediate and longer term maturities. The key metric that I look at in terms of how successful the authorities are in rekindling economic growth is the shape of the yield curve. The difference between 2 year and 10 year Treasury notes is the yield curve indicator that I closely watch. Over the past few decades this metric has averaged around 75-80 basis points (10 year rates – 2 year rates). It has also undergone some wide swings. The more positive the number, the more the bond market expects that the authorities will succeed at re-inflating the economy. The yield curve has been trading just below 200 basis points most recently. This barrier must be convincingly broken and substantially exceeded before I will be convinced that the stimulus is gaining traction. At this time it looks to me like the resistance at the 200 level wants to hold.

NOTEWORTHY: The economic calendar was quite busy during the holiday shortened past week. The state of manufacturing is dismal. Both the Empire State and Philly Fed surveys on manufacturing dove precipitously. The Empire survey fell 12 points to -34.6 while the Philly survey crashed 17 points to -41.3. Housing Starts had another massive 17% drop to 466k units, while Building Permits only (??) declined 5% to 521k units. As the housing sector meltdown continues, analysts are still playing catch-up with their forecasts as to the severity of the decline in the activity in this sector. Industrial Production fell 1.8% as Capacity Utilization declined from 73.3 to 72% in January. Both of these data points were also below consensus expectations. Weekly Jobless Claims remain at elevated levels as they were unchanged at 627k for the latest reading.

The inflation data was slightly higher than expected both on the Producer and the Consumer fronts, but the market did not seem to mind as inflation is not an issue at this point. The Canadian economic data was highlighted by the Consumer Price Index release. In contrast to the US , Canadian CPI fell in January both on the headline and Core readings. The year over year data for Canadian inflation has now declined to 1.1% while the more stable Core measure is at 1.9%. Both these data series are expected to continue their decline opening the door for further rate cuts for the Bank of Canada. Next week's schedule will be highlighted by more housing data, consumer confidence surveys, the Durable Goods Orders report and the first revision of the Q4 GDP data.

INFLUENCES: Sentiment surveys are about as neutral as neutral gets. The Commitment of Traders reports showed that Commercial traders were net long 287k 10 year Treasury Note futures equivalents – a decline of 28k from a week ago. This remains supportive for bonds. I would still like to see the COT data show Commercial positions negative in order to turn wildly bearish on the bond market. It is just not happening as this metric remains stubbornly high. Seasonal influences are negative. The technical picture is damaged, so I don't expect the Long Bond future to recover a great deal. The market is trying to hold and even do a little better around the present level. 124 was the break-out level for bonds on the way up. It is major support on the correction. If 124 gives on the futures and 3% fails to hold on the 10 Year Treasury Note yield, this market could turn quite ugly in a big hurry, but my indicators tell me that these support levels should hold.

RATES: The US Long Bond future traded up a point and a half to 127-20 last week, while the yield on the US 10-year note declined 10 basis points to 2.79%. The Canadian 10 year yield decreased 7 basis points to 2.93%. The US yield curve was flatter as the difference between the 2 year and 10 year Treasury yield fell to 185 basis points, which is a decrease of 8 basis points.

BOTTOM LINE: Bond yields fell, while the yield curve was flatter last week. The fundamental backdrop remains pathetic, which is supportive for bonds. Trader sentiment is neutral; Commitment of Traders positions are supportive and seasonal influences are negative. My bond market view is slightly positive here.

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

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