US Bond Yields Fall as Economies Continue to Weaken

By: Levente_Mady

The Treasury market has been stair-stepping higher since the middle of July. The US Long bond is closing in on the top of its annual range as the summer draws to a close with the Labour Day weekend upon us. It is time to take deep breath and have a look at what the big picture looks like. Naturally, we are most interested in how this picture will impact interest rates going forward.

The name of the game over the past 20 months (since the beginning of 2007) has been “contagion” and just how far it goes. We started with problems in sub-prime, then housing, then the structured alphabet soup of MBS, CMO, ABCP, SIV, etc., then the financial co. alphabet soup of CFC, BSC, MBIA, FNM, FRE – just to mention a few -, then it was municipal bankruptcies, auction rate securities and international economic issues. I apologize for not coming up with a more comprehensive list. But hopefully the reader will get the idea. Three quarters of the world's economies have slowed to a crawl and the rest are not far behind. The bad news is that the real engine behind the global economic growth – the US Consumer – has not hit the wall yet. As per the latest data below, the US Consumers magically continue to spend beyond their means. I focus on that single metric for clues of when the REAL slowdown will begin.

I really couldn't care less what all them smart talking heads are saying about BRIC countries and all, once the American Consumer packs it in, they will be toast as well. China for example is an export based economy; she has nowhere close to enough domestic demand to keep her economy going without major help from abroad. A deteriorating employment scene combined with a suffocating level of consumer debt tells me that the proverbial wall to hit for Mr. and Ms. Consumer is not far now. And that is the story that the bond market is telling us as it is looking to claw its way to new high ground in spite of negative real rates, inflation worries and massive amounts of new supply.

NOTEWORTHY: The economic data was disappointing but in general stronger than consensus expectations. Existing and New Home Sales both ticked up during July. Existing Home Sales exceeded expectations at 5 Million units while New Home Sales were below consensus at 515k units. Inventories remain at record levels while the median price fell 6.1% for New and 7.1% for Existing Homes year over year. Consumer Confidence increased a couple of points in step with declining gasoline prices over the past couple of weeks. However, the absolute readings on both the Conference Board and the University of Michigan surveys remain depressed. Just to make matters worse, the Employment component of the Conference Board survey continues to deteriorate. Durable Goods Orders increased 1.2% in July, beating expectations of a flat reading. The Q2 real GDP figure was revised up from 1.9% to 3.3% topping expectations. The nominal Q2 GDP number was 4.5%.

Weekly Jobless Claims declined 10k last week to 425k. Personal Income declined 0.7% in July while Spending increased at a 0.2% clip during the same period. Nice to see that the consumer in the US of A continues to follow the path of the Energizer Bunny: just keeps spending and spending and spending what they don't have. In Canada the news was somewhat weaker. Canadian Q2 GDP was reported at 0.3%. After a 0.8% Q1 contraction, that leaves the Canadian economy contracting marginally over the first half of 2008 and expanding at a 0.7% rate year over year. Curiously nominal GDP actually expanded at a 10.6% rate (more than double the US rate), but the Canadian Q2 Chain Price Index was a SOMEWHAT more realistic 10.5% compared to the GDP Deflator of 1.2% that was calculated for the same time frame in the USA.

One might even suspect that there is an election or something coming up down there for them to cook the books like that. The Bank of Canada has a policy meeting scheduled for next week; the implications for rates are fairly clear based upon the latest Canadian economic data: expect stable to lower interest rates going forward. Next week's headliners will include the ISM Surveys, Auto Sales, Factory Orders and the world famous monthly Employment Report.

INFLUENCES: Trader surveys ticked up into slightly overbought levels on bonds during the latest week. The Commitment of Traders reports showed that Commercial traders were net long 211k 10 year Treasury Note futures equivalents – an decrease of 114k from last week. This is now neutral for bonds. The positive seasonal influences are diminishing into the beginning of September. The 10 year note yield slowly drifted toward 3.75%. My view is becoming slightly negative; I expect the 10 year note yield to head back up toward 4%.

RATES: The US Long Bond future traded up half a point to close at 118-06, while the yield on the US 10-year note decreased 5 basis points to 3.81%. The yield curve was essentially 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 decreased 3 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 was unchanged last week. The fundamental backdrop remains bleak. Trader sentiment is leaning bearish while COT positions as well as seasonal influences are neutral. The recommendation is to stay with the curve steepener, and continue 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

The data and comments provided above are for information purposes only and must not be construed as an indication or guarantee of any kind of what the future performance of the concerned markets will be. While the information in this publication cannot be guaranteed, it was obtained from sources believed to be reliable.  Futures and Forex trading involves a substantial risk of loss and is not suitable for all investors.  Please carefully consider your financial condition prior to making any investments.

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© 2008 Levente Mady, All Rights Reserved

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