U.S. Bonds Weaker in advance of Massive Issuance of Bailout Treasury Bills

By: Levente_Mady

The bond market lost 4 points last week as the yield on the 10 year note gravitated back to the 4% level that seems to be acting as a magnet of equilibrium these days. While the bounce in the stock market has put some pressure on US Treasury and other government bonds, the real driver for interest rates at the present time is supply. There are certainly a number of other problems that are supportive for the bond market, but all the bailouts, guarantees and government as well as Federal Reserve programs will have to be paid for. It will be done with a massive increase in the issuance of Treasury Bills, Notes and Bonds.

During the next year or so, the Treasury will be faced with issuing over $2 Trillion of new debt. The first glimpse of how some of this supply may be distributed will come on Wednesday when the Treasury will announce the schedule and size of its quarterly refunding. The bond auctions will be conducted during the second week of November, the maturities and amounts to be auctioned off will be announced on Wednesday. We already know that bonds sold off sharply a couple of weeks ago when the Treasury surprised the bond market with $40Billion of unscheduled 10 year paper, it will be interesting to see how supply will be received during the next couple of weeks. My guess is that yields will remain in an uptrend into the auction and drop sharply thereafter.

Central Banks remain in easing mode. Last week it was the US Federal Reserve Bank's turn to cut its benchmark rate from 1.5% to 1%, with a couple of other smaller Central Banks lowering rates as well. Next week the European Central Bank and the Bank of England are scheduled to have the rate cut parties.

I almost forgot to mention that the results of the US election may be another market mover this week. As we go to press, the only question mark seems to be whether the Democratic landslide will extend beyond 60 seats in the Senate. That scenario would entail more bad news for the bond market.

NOTEWORTHY: The economic calendar was busy last week. New Home Sales remain depressed as price declines start to gain momentum. The median price of a new home fell 9.1% year over year in the US through September. The plunge in the preliminary reading of the Michigan Consumer Confidence report of a couple of weeks ago was confirmed by the final reading in that survey as well as a steep drop of 23 points to a record low reading of 38 in the Conference Board's survey. Durable Goods Orders increased 0.8% in September, but the previous month's large drop was revised even lower from 4.5 to 5.5%. The Preliminary GDP report for the third quarter was pegged at -0.3%.

Weekly Jobless Claims were stable last week at 479k. Personal Income increased 0.2% while Personal Spending fell 0.3% in September. Both these series are declining. The Canadian economic activity declined 0.3% in August as measured by the GDP report. The year over year economic growth now stands at an anemic 0.6% and it is expected to decline further. Canadian Industrial Production also declined (by 0.8%) in August. Industrial Prices fell 1.2% in September, so they are up only 8% from a year ago. Next week's schedule in the US will be highlighted by the Purchasing Manager surveys and the monthly Employment report.

INFLUENCES: Trader surveys are stabilizing at neutral levels providing no clues for the next move in the bond market at this juncture. The divergence in sentiment is quite shocking as the Chicago futures crowd is 2/3 bullish while the New York Wall Street crowd is 2/3 bearish on the Treasury bond market according to the latest data. If anyone out there can give me any insight as to any significance this divergence might have, I would much appreciate it. The Commitment of Traders reports showed that Commercial traders were net long 374k 10 year Treasury Note futures equivalents – an increase of 8k from last week. This is somewhat positive for bonds. Seasonal influences are negative here for the next week or so. The view remains slightly negative.

RATES: The US Long Bond future traded down 4 points to close at 113-04 – back to within a whisker of where it was 2 weeks ago, while the yield on the US 10-year note increased 27 basis points to 3.96%. The yield curve was steeper and while I am retaining my steepening bias, I suggest that all my readers who made truckloads of money on this trade start lightening up somewhat at this point. I first recommended this trade when the yield curve was inverted by about 50 basis points a year and a half ago, so the 270 basis point gain is not too shabby. 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 22 basis points to 240 last week. I still believe the path of least resistance is toward further steepening (over 300 basis points not too far fetched) but the rubber band is getting stretched and the risk reward is certainly not nearly as attractive as it was when the 2 year yield traded below the 10 year note yield.

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

BOTTOM LINE: Bond yields jumped sharply higher, while the yield curve was steeper last week. The fundamental backdrop is just getting worse, which is supportive for bonds. Trader sentiment is neutral, Commitment of Traders positions are supportive but seasonal influences are quite negative. It will be raining bonds during the next 2 weeks. My bond market view is neutral at best.

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

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