Treasury Market Takes a Pounding, Dropping to New Lows for 2008

By: Levente_Mady

The Treasury market dropped to new lows for 2008 last week. The drumbeat of inflation concerns just became a little louder not only in the USA but also internationally. Oil and its surrogates keep trucking up to new highs and corn is certainly keeping pace with them. Central Banks are talking tough but until I actually see the Fed raise rates, I remain a skeptic as to how much they are really willing to do in order to reign in the runaway commodity inflation. Although I fully believe in peak oil, I also figure that the ongoing slowdown in the global economy coupled with surprising progress in the alternative energy space will eventually reign in the present energy price problems.

As per the sentiment survey mentioned below, the consumer is severely depressed, but that does not mean that she has stopped spending yet. My 2 favourite trades from the past couple of letters - 1, buy bonds - sell stocks and 2, buy short term bonds - sell long term bonds, i.e. the yield curve steepening trade – continued to work well in the first case, and it got to a neutral reading, good enough to take some profits on the trade, but the second recommendation moved sharply against us. For the reasons described in this note, we are staying with this second recommendation a while longer.

NOTEWORTHY: The economic data calendar was fairly busy last week. Pending Home Sales bounced 6.3% in April. This has got to be the first data point in well over a year in the housing sector that showed a noticeable increase. Not that I think it makes any difference. Housing is and will remain in terrible shape for years to come. The Trade Deficit soared $4.4Billion in April; driven pretty much by energy prices going ballistic. At the end of April Crude Oil was trading around $111 per barrel. Now it is much closer to $135. Look for further increases on the Trade Deficit going forward. The latest figures I saw on Import Price inflation was 17.3% over the past 12 months. You can bet that this figure will not be decreasing any time soon either. Retail Sales jumped 1% in May as consumers continue to borrow (as per the previous week's release of Consumer Credit) and spend as much as they can.

The fiscal stimulus checks were obviously aiding this activity as well. Consumer credit is expanding at 6+% while Retail Sales are up 2.2% year over year. It certainly appears that even with help from Uncle Sam (stimulus checks) and the Fed (lower interest rates), there is a major drag on consumer spending (the difference between the rate of increase of consumer credit and retail sales is about 4%. In this environment of negative real interest rates there is not much incentive to save, so I suspect the bulk of that 4% discrepancy must be chewed up by servicing outstanding consumer debt. The Michigan Consumer Sentiment Survey crashed to another new all-time low registering a reading of 56.7 (100 is neutral). With the job market quickly deteriorating (if it wasn't for seasonal and other adjustments, the Unemployment rate would be well over 6% by now and once these adjustments turn negative later this summer, we will quickly get there and higher), sky high energy prices (which have not quite sunk in yet), credit becoming increasingly difficult to come by and now interest rates creeping up to make debt servicing even worse, it is no big surprise that consumer confidence is at depressionary levels.

Does anybody think that the Bernanke Fed will actually raise rates under these circumstances? Actually, I reckon it would be quite ironic if Helicopter Ben led the charge to stamp out inflation and put not only the US but the global economy into a deep, extended recession if not worse. Somehow I have an easier time buying Treasury Secretary Paulsen's “strong dollar policy” garbage than imaging the Fed raising rates. Wee kly Jobless Claims increased 25k to 384k last week. CPI increased 0.6% in May and 4.2% over the past 12 months. Next week's headliners will include the NY Empire State and the Philly Fed Manufacturing Indexes, PPI, Housing Starts, Capacity Utilization, Industrial Production and the Index of Leading Economic Indicators.

INFLUENCES: Trader surveys remain in neutral territory on bonds during the latest week. The Commitment of Traders reports showed that Commercial traders were net long 387k 10 year Treasury Note futures equivalents – an increase of 98k. The COT data is now providing the bond market with a solid tail wind. Seasonals remain positive. After trading either side of 4% for a few weeks, the 10 year note yield rocketed to new highs past 4.25%. The positive factors are still dominant, but until the 10 year yield sees some follow through under 4%, it is going to be difficult to get excited about the technical picture.

RATES: The US Long Bond future traded down 2½ points to close at 112-17, while the yield on the US 10-year note increased 34 basis points to 4.26%. The yield curve was sharply flatter and I am expecting that it will retain a steepening bias. Long-short accounts can take advantage of the steepening trend by buying 2 year Treasuries against selling 10 year Treasuries on a risk weighted basis using cash or futures. This spread decreased 30 basis points to 123 during the past week.

CORPORATES: Corporate bonds remain overvalued, especially the weaker credits.

BOTTOM LINE: Bond yields increased sharply and the yield curve became flatter last week. The fundamental backdrop remains bleak. Trader sentiment is neutral, while COT positions and seasonal influences are positive. The recommendation is to stay with the curve steepener, and continue to shun the weaker corporate credits. My bond market indicators are still positive, but I am going to keep my bullish bias in the closet for now.

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

The data and comments provided above are for information purposes only and must not be construed as an indication or guarantee of any kind of what the future performance of the concerned markets will be. While the information in this publication cannot be guaranteed, it was obtained from sources believed to be reliable.  Futures and Forex trading involves a substantial risk of loss and is not suitable for all investors.  Please carefully consider your financial condition prior to making any investments.

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