Escalating Bailout Band-aids Hit US Treasury Bonds

By: Levente_Mady

Bonds traded mostly in negative territory all last week. It looks like it is just regular business these days: another week, another bail-out package. The figure that is bandied about for the latest and greatest deal is a cool $700 Billion. It is just another band-aid in a series of larger and larger band-aids that hopes to provide quick relief for the symptoms of this gigantic financial crisis without addressing the real problem of dealing with the excess credit that has been built up on the consumer, corporate and government fronts. It will be raining Treasury bonds in the foreseeable future, so it is no wonder that the increasing weakness on the fundamental front is not providing much support for lower yields in the long term maturities at this juncture.

I have just one quick note on Central Bank lending rates: I still expect them to move lower. Although the Fed surprised the market somewhat by not lowering the Fed Funds rate at their latest policy meeting the other week, I don't think that this decision indicates that they are finished easing. One clue for the change in climate toward lower rates is that the members of the policy setting committee were unanimously in favour of holding rates this time in contrast to the previous meeting where 2 people voted to actually raise rates. Even the toughest of the tough Fed members realize that there is no reason to hike rates. As we get further economic weakness and lower inflation readings, the Fed – and other Central Banks - will have more of a fundamental argument for lowering rates. As far as the credit crunch is concerned, the major problem there is that the credit transmission mechanism is broken, which will not be solved by lowering the Fed Funds rate from 2 to 1.5%.

In spite of the short selling ban on financial stocks, Washington Mutual – which I believe was the fifth largest US financial institution by deposits – is now also bankrupt. And it does not seem to help Wachovia Bank either, which is desperately searching for suitors to bail out its sinking boat. On the international front, Fortis - Belgium 's largest bank - is getting rescued by a $16Billion+ package put together by the governments of Belgium , Holland and Luxemburg. On the other side of the coin, Warren Buffett just took a big leap into the ongoing mess in the financial sector. Jimmy's brother (???) decided to take the plunge by purchasing $5Billion worth of Goldman Sachs equity. While some people may take this as a signal that the coast is clear and it is fine to jump into the fray, even if we have a bit of a bounce here, I still believe that there is more pain to come.

NOTEWORTHY: The economic calendar was light but the data reported was unequivocally horrible. So while the authorities are busy with ever growing bail outs in the financial sector, it is easy to miss the ongoing deterioration of the economic landscape. The housing data is getting relentlessly worse stateside. Both Existing and New Home Sales declined both in volume and median selling price terms again in August. Durable Goods Orders declined 4.5% during the same time period. Wee kly Jobless Claims rose 32k last week to 493k. Although the latest increase was attributed to disruptions caused by the latest slew of hurricanes, the increasing trend is evident. Second quarter GDP was revised down to 2.8% from a previously reported 3.4%.

In addition – I suppose miracles just don't cease to happen – the Chain Deflator (the GDP's inflation component) was revised down from 1.2 to 1.1%!!! In spite of lower gas prices, Consumer Confidence dropped 3 points to 70. Canadian Retail Sales increased marginally in July, but the year over year number stands at a respectable 4.9%. The Canadian Consumer Price Index actually declined 0.2% in August, but the year over year figure increased to a multi-year high of 3.5%. Next week's reports will be highlighted by the ISM surveys on the state of the manufacturing and service sectors and the monthly Employment data.

INFLUENCES: Trader surveys are still at optimistic levels on bonds, but they have moderated over the past week. This provides a headwind for the market. The Commitment of Traders reports showed that Commercial traders were net long 332k 10 year Treasury Note futures equivalents – an increase of 49k from last week. This is slightly negative for bonds. The seasonal influences are positive next week but turn sharply negative thereafter. The 10 year note yield is inching higher in spite of strong fundamental support. Yields may dip temporarily as month/quarter end window dressing usually brings in buyers. Once that influence is out of the way, my view remains slightly negative; I expect the 10 year note yield to head back up toward 4%.

RATES: The US Long Bond future traded down close to a point to close at 117-14, while the yield on the US 10-year note increased 4 basis points to 3.85%. 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 11 basis points to 175 last week.

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

BOTTOM LINE: Bond yields were slightly higher, while the yield curve was steeper again last week. The fundamental backdrop is grim, which is supportive for bonds. Trader sentiment is overly bullish – which is negative - while Commitment of Traders positions as well as seasonal influences are fleetingly positive. 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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