Bonds Slump as Equities Recovery from the Abyss

By: Levente_Mady

After extending its gains for a 4th week in a row, the Treasury market pulled back as equities recovered from the abyss. The trend of bonds and energy trading in lock-step remained intact as bonds now sold off as energy prices corrected sharply. There was a recovery in stocks – especially financials during the latter part of the week, so the reverse safe-haven flows pressed bonds lower. The sharp increase in headline inflation also added fuel to the sell-off. Real returns on Treasury bonds are now negative across the entire yield curve, as even 30 year bonds provide a -.35% return after adjusting for inflation. That is great news for spenders and the government (who gets to borrow massive amounts of money at ultra low rates) but not so good for savers.

The drumbeat of anti-inflationary rhetoric continues from various Fed officials. The Fed has never raised rates in a rapidly deteriorating employment environment like the one we are experiencing now. In spite of the fighting words, I don't think the Fed is about to change tactics on that front, especially heading into a presidential election campaign. The shorter maturities of the yield curve remained well supported. I am standing by my forecast that the Fed is months if not years away from changing the Fed Funds rate and when they do, they will be more likely lowering - not raising rates as the consensus would have you believe at this point.

NOTEWORTHY: The economic data shows the worst of both worlds: higher inflation with an ongoing slowdown in economic activity. The 2 economic indicators that I consider most significant are Consumer Credit and Retail Sales. The consumer is over 70% of the US economy and the afore mentioned indicators are in my opinion the best gages of the state of the consumer, which unfortunately is less than stellar and still deteriorating. Consumer Credit increased $7.8 Billion in May, well exceeding expectations of a $5Billion increase. Credit card debt exploded another $5.7 Billion alone.

Consumer Credit continues to grow at an unsustainable pace of close to 6% per annum. I just cannot believe that nobody seems to be paying attention to this key data series. When growth in this series runs out of steam, the real economy will truly be in dire straights. Retail Sales meanwhile were essentially flat (up 0.1% to be exact), but that is a mirage as consumers just ended up paying more for less gas. Excluding gasoline sales, Retail Sales declined 0.5% in June. So the story of almost ¾ of the US economy is the following in a nutshell: consumers continue to borrow more but can afford to buy less and less even in spite of the boost from the government rebate cheques during the second quarter. On the inflation front, both PPI and CPI increased not only massively, but also significantly higher than consensus expectations. PPI is up 9.2% year over year, while CPI jumped 5% during the same time frame.

According to Shadowstats, CPI is now growing at a double digit rate using the pre-1982 measurement criteria. The media was prematurely hailing improved Housing Starts data as the potential bottom for housing. The near 10% jump in the June figure was due to a statistical adjustment in the New York City construction code. Without this adjustment, Starts actually declined 4%. Meanwhile the NAHB Builder's Survey plunged another 2 points to 16 – another all time low. Housing is far from being out of the woods yet folks. Wee kly Jobless Claims increased 18k to 366k last week after plunging over 50k the week prior to that. Next week's headliners will include Leading Economic Indicators, Existing and New Home Sales, Durable Goods Orders and the Michigan Consumer Sentiment survey. Most of these data points are considered to be second tier, so they should have a muted effect on the market.

INFLUENCES: Trader surveys remained neutral on bonds during the latest week. The Commitment of Traders reports showed that Commercial traders were net long 252k 10 year Treasury Note futures equivalents – a decrease of 168k from a couple of weeks ago. The COT data is providing the bond market with a slight tail wind. Seasonals are neutral to negative this week and they will turn sharply positive heading into the end of the month. After trading down below 3.80% last week, the 10 year note yield settled back above 4%. The positive factors are diminishing; the increase on the 10 year yield above 4% tilts the bias to bearish on the technical front. My view on the market is neutral; I expect more sideways action around 4% going forward.

RATES: The US Long Bond future traded down a point and a half to close at 114-10, while the yield on the US 10-year note increased 11 basis points to 4.08%. The yield curve was slightly steeper 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 increased 2 basis points to 146 during the past 2 weeks.

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

BOTTOM LINE: Bond yields increased, but the yield curve was slightly steeper again last week. The fundamental backdrop remains bleak. Trader sentiment and COT positions are neutral but seasonal influences are negative. The recommendation is to stay with the curve steepener, and continue to shun the weaker corporate credits. My bond market indicators are dead neutral, so I am looking for the market to in a range around the 4% yield level on the 10 year Treasury Note.

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

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