Fed to Keep Interest Rates on Hold for Months if Not Years

By: Levente_Mady

The Treasury market finally showed some signs of life last week after a multi-week annihilation. It was a relatively quiet week in bond land as traders were more preoccupied with ever rising energy prices and ever increasing problems in the financial sector. After many months of deliberations the rating agencies finally got around to downgrading the bond insurers. 2 observations are in order here: 1, don't ever never ever never rely on the rating agencies for advice as they are severely, severely lagging indicators and they have a huge conflict of interest and 2, make sure you have a chuckle and quickly dismiss anyone who is trying to sell you on the idea of efficient markets.

The cat was let out of the bag before the end of 2007 that the bond insurers should in no way shape or form be rated AAA in their financial condition at the time, but 6 months later when they actually got downgraded we are seeing overwhelming dislocations as yields again exploded to the upside on some of the weaker municipal credits.

Next week the FOMC meets again and will be issuing a statement on the state of the economy and the Feds interest rate policy in the economic context. I expect that there will be more saber rattling on the importance of being vigilant on inflation, but there should also be some mention about continued loss of momentum in economic growth. The bottom line is that it would be a colossal shock if the Fed did anything but keep rates unchanged at 2%. At the same time I reiterate that contrary to popular belief, I 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.

Early in May I first recommended to buy bonds and sell stocks in a spread trade. Since that recommendation was first put forward bonds fell 1.4% and stocks are down 6.5% for a 5.1% profit before leverage. The recommendation now is to take your money and run. The other trade idea to buy short term bonds - sell long term bonds, i.e. the yield curve steepening trade – improved a smidge and it continues to make sense.

NOTEWORTHY: The economic data calendar was on the weak side again last week. The Empire State and the Philly Fed Manufacturing surveys both declined and they were reported below expectations. PPI increased a massive 1.4% in May and it is up 7.2% from a year ago. On the other hand, core PPI increased only 0.2% for a year over year figure of 3%. So as long as you don't need to eat, drive or heat (air condition) your home, inflation is well behaved in your world. More dismal news on the housing front as May Housing Starts fell another 3% to a new multi decade low. Industrial Production fell for the third time in the past four months as Capacity Utilization declined in sympathy.

Capacity Utilization has been below the non-inflationary threshold of 80% for the second consecutive month and it appears to be trending lower. Weekly Jobless Claims decreased 5k to 381k last week. Leading Economic Indicators managed to eke out a 0.1% gain for the second month in a row, but the year over year figure is stuck at -2%. Meanwhile, north of the border in Canada , CPI popped 1% in May lifting the annual rate from 1.7% to 2.2%. With the loonie running out of steam and now only up 3% from a year ago, this report should not come as a big surprise. The Canadian dollar has actually declined over 10% from the high watermark set last November, so we are looking for further increases in this data series as we head into the second half of the year. Next week's headliners will include the Conference Board Consumer Confidence survey, Durable Goods Orders, New Home Sales, Existing Home Sales as well as Personal Income and Spending data for May.

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 476k 10 year Treasury Note futures equivalents – an increase of 89k. The COT data is now providing the bond market with a strong (an upgrade from solid) tail wind. Seasonals remain positive. After trading up to 4.31% last week, the 10 year note yield settled back somewhat lower. The positive factors are increasingly 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 up over 1½ points to close at 113-14, while the yield on the US 10-year note decreased 12 basis points to 4.14%. The yield curve was pretty much unchanged 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 4 basis points to 127 during the past week.

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

BOTTOM LINE: Bond yields dropped lower and the yield curve was pretty much unchanged last week. The fundamental backdrop remains bleak. Trader sentiment is neutral, while COT positions and seasonal influences are quite supportive. The recommendation is to stay with the curve steepener, and continue to shun the weaker corporate credits. My bond market indicators are even more positive than last week, but I am going to keep my bullish bias in the closet for now.

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

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