US Treasury Bonds Auctions to Put Dampener on Bond Market Rally

By: Levente_Mady

In spite of the bounce in the financial stocks, the negative news continues to pour in on the earnings (or lack thereof) front in that sector. Last week we saw Merrill Lynch in the news again as they wrote off another $5 billion+ in assets. Leading basket cases Fannie and Freddie will be rescued by the government but that will not be much help to the shareholders. Ongoing problems on this front are likely to support the bond market.

Next week the Treasury market will have a slightly different focus from the second tier economic data and the other markets such as stocks, energies and currencies. The Treasury will conduct a couple of quarterly refunding auctions: 10 year notes on Wednesday and 30 year bonds on Thursday. The auctions usually have a negative effect on the bond market, especially in the case of long term supply such as the upcoming issues.

The other event of some significance will be the FOMC policy meeting on Tuesday. The Fed has never raised rates in a rapidly deteriorating employment environment like the one we are experiencing now. Last week's employment news pretty much ensured that the Fed will leave rates unchanged next week. 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 was mixed again but only relative to expectations last week. The Conference Board's Consumer Confidence ticked up 0.9 to 51.9 in July. It was 2 points higher than expected, but still only about 51.9% of what is considered neutral. The economic bulls were dancing in the streets! Crazy Cramer officially pronounced the bear market dead. The advance release of the Q2 GDP was worse than expected at 1.9% relative to 2.3% consensus forecasts. Not only was the GDP figure lower than expected, but puzzlingly the Deflator (the Price Index used for GDP calculations) was reported at 1.1% relative to expectations of a measly 2.4% increase. I wonder what the good folks at the BEA put in their gas tanks while they calculate the Deflator. PPI is close to 10%, CPI over 5% and the deflator at 1%??? ONE-POINT-ONE-PER-CENT! That is simply remarkable.

On the other hand it also means that nominal GDP growth was measly 3% versus expectations of 4.7% (2.3% real GDP + 2.4% Deflator). Wee kly Jobless Claims exploded 44k to 448k last week. That is terrible news on the employment front. The monthly unemployment report wasn't any better news in spite of Non-Farm Payrolls slightly exceeding expectations. The headline unemployment rate jumped 0.2 to 5.7%, while the absolute number was reported at -51k for its 7 th consecutive decline on the Payroll series. While the markets had a slightly positive reaction immediately after the report (with stocks up and bonds down), by the end of the day reality set in as bonds closed green while stocks finished red. Auto Sales plunged again in July to a seasonally adjusted annual rate of 12.55 million units. This is the lowest figure since 1992 and it is a decline of over 30% from the peak of a couple of years ago. Next week's headliners will include Personal Income and Spending, Factory Orders, Consumer Credit as well as Pending Home Sales.

INFLUENCES: Trader surveys remained neutral on bonds during the latest week. Bullish sentiment continues to tick up, but it is a little ways from excessive readings that could cause problems. The Commitment of Traders reports showed that Commercial traders were net long 458k 10 year Treasury Note futures equivalents – an increase of 87k from last week. This is providing the bond market with a decent tail wind. The recent jump in the data is more meaningful in the context of dropping open interest in both the 10 year note and the long bond contract. Seasonals are neutral for next week before turning sharply positive for the rest of the month. As expected, the 10 year note yield continues to hover around 4%. My view on the market is neutral; I expect more sideways action around 4% on 10 years. It is a terrific environment for strangle writing in option land.

RATES: The US Long Bond future traded up over 2 points to close at 115-29, while the yield on the US 10-year note decreased 17 basis points to 3.93%. 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 4 basis points to 144 last week.

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

BOTTOM LINE: Bond yields dropped lower, while the yield curve tilted slightly steeper last week. The fundamental backdrop remains bleak. Trader sentiment is neutral but COT positions are supportive. Seasonal influences are slightly negative next week before they turn positive for the rest of the month. 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 stay in a range around the 4% yield level on the 10 year Treasury Note until further notice.

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

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