US Treasury Bonds Experience Massive Volatility

By: Levente_Mady

Along with the rest of the financial markets, the US Treasury market experienced massive volatility during the past week. The Long Bond future traded up over 5 points before ending the week almost unchanged. The 30 year Treasury bond yield traded below 4%, which is the lowest level in over 40 years. Even more significantly, the US 3 month Treasury Bills yielded less than 0.1% for a couple of days as financial markets threatened to seize up. All of the sudden drawing comparisons – even in the main stream media - with the 1990s Japanese depression and the Great Depression of the 1930s does not seem so far fetched any more. It took us years if not decades to get into this mess, I expect it will take a little longer than 3 to 6 months to get out!

On the one hand, the US Federal Reserve Board decided to leave their benchmark overnight rate unchanged at 2% last Tuesday – not that is matters much with 3 month bills trading at 0.1%, while on the other hand, the Fed, the Treasury and other Central Banks around the world threw hundreds of billions of dollars at the market to engineer another last ditch effort to save the world financial system from seizing up. The Federal Reserve takes collateral from financial institutions when they lend out money. Not long ago, the collateral accepted was only of the highest quality such as US Government Treasury Bills and Bonds. Now they accept just about any securities including equities. At the rate they are going, it will not be long before they start accepting used furniture and the kitchen sink as security for cash injections.

By the end last week it looked like the financial world has been saved yet again as equity markets world wide rallied over 10% in most cases from their lows. So what is there to cheer about? Increased restrictions and regulation, decreased efficiency that comes with government oversight, additional costs associated with more red tape are not exactly what bull markets are made of. A prime example of an instant impact is the effect of banning of short sales on the liquidity in the options market. It has been significantly diminished. It is expected to get worse next week. In a strong show of solidarity, the UK, US and Australia all banned short sales.

I did not see any headlines about the Dubai or the Tehran stock exchanges joining that party. I suppose after the US lost a great majority of its manufacturing jobs over the past few decades, now the time has come to transfer a significant portion of financial jobs overseas due to excessive regulation not only regarding short sales, but all the nonsense surrounding futures trading regulation as well. And we have not even touched on the loss of credibility of the US financial leadership due to the turmoil created by the events of the past year or so.

NOTEWORTHY: The economic data was disappointing again last week. Manufacturing surveys were mixed as the NY regional index dropped 9 points to -7.4 while the Philly Fed survey jumped 16 points to 3.8. Capacity Utilization declined 1% to 78.7 in August, while Industrial Production fell 1.1%. The Consumer Price Index declined 0.1% last month, aided by lower commodity prices. Wee kly Jobless Claims rose 10k last week to 455k. On the housing front, there is still no light at the end of the proverbial tunnel. Housing starts plunged another 6% to a new multi-decade low of 895 units in August, while July starts were revised down 1%.

Building permits are forecasting further downside for this data series. Leading Economic Indicators are predicting further weakness for the economy ahead. The latest figure declined 0.5% for the month, while the year over year number stands near -3%. The Canadian housing market seems to be following in the US ' footsteps. Existing Home Sales have now declined 20% year over year north of the border. Next week's reports will include Existing and New Home Sales, Durable Goods Orders and the Michigan Consumer Confidence Survey.

INFLUENCES: Trader surveys are now at overly optimistic levels on bonds. This provides a stiff headwind for the market. The Commitment of Traders reports showed that Commercial traders were net long 283k 10 year Treasury Note futures equivalents – an increase of 63k from last week. This is still neutral for bonds. The seasonal influences are neutral for the rest of September. The 10 year note yield dipped as low as 3.22% before jumping back up to 3.81% by the end of the week. It is struggling to hold below 3.75% in spite of strong fundamental support. My view is slightly negative; I expect the 10 year note yield to head back up toward 4%.

RATES: The US Long Bond future traded down half a point to close at 118-05, while the yield on the US 10-year note increased 9 basis points to 3.81%. The closing prices are a tad misleading as we had several trading days with 3-4 point ranges. The yield curve was steeper and I am retaining my 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. This spread increased 12 basis points to 164 last week.

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

BOTTOM LINE: Bond yields were slightly higher after a wild rollercoaster ride, while the yield curve was steeper last week. The fundamental backdrop continues to deteriorate, which is supportive for bonds. Trader sentiment is overly bullish – which is negative - while Commitment of Traders positions as well as seasonal influences are neutral. The recommendation is to invest in the 2 year Treasury and Canada bonds, and to shun the weaker corporate credits. I am expecting the 10 year Treasury Note yield to drift back up toward 4%.

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

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