U.S. Treasury Bond Market Expected to Surprise to the Upside

By: Levente_Mady

The bond market traded sideways in July.  This is remarkable in light of the events that have transpired last month in the financial markets.  The risk trade remained in vogue for another month as stocks, commodities and peripheral currencies powered ahead.  Chinese equities have almost doubled from their lows and they have led the charge in emerging market equities.  Market participants however fully realize that efforts to re-flate prices only have a chance in a steady to declining interest rate environment. 

As a result, in spite of a continued onslaught of Treasury bond and note supply, rates remained stable to slightly lower.  Even last week’s dismal Treasury Note auction results did not seem to have anything more than a brief and very shallow effect on the bond market.  Bonds may really surprise to the upside (to lower yields) once the risk trade runs out of steam.  In the meantime, investing in long Treasuries will provide higher yields than sitting in “shorts” near 0%.

Meanwhile in the real world, we had 5 more banks shut down by the authorities this weekend.  That takes the count up to 69 and counting for this year.  In spite of “record” earnings from Goldman Sachs and others in the financial space and an ongoing rally for a number of stocks in the sector, all is not well.  The market is only as good as the last stimulus package or the next band-aid such as the newly popular cash-for-clunkers program devised by the government.

NOTEWORTHY:  The economic calendar was another mixed bag last month.  Rather than analyze each data point as per previous practice, let’s step back and look at the monthly data in order of importance according to me.  The consumer is 70% of the economy so I would like to start with the consumer related data.  How is the consumer doing?  Not too well, I’m afraid.  First of all, on the employment front, close to another half a million people lost their jobs, while the official unemployment rate ticked up to a multi decade high of 9.5%. 

Economists are looking for more bad news on the employment front.  Much has been made about the sharp drop in the Weekly Initial Jobless Claims.  They fell from 675k to 524k in a matter of a few weeks, but they ticked up 60k to 584k during the past couple of weeks.  Well, they did not really fall as much as the data shows; they were just seasonally adjusted down.  In the mean time Continued Benefits fell about 800k in the past 4 weeks to 6.2 million.  The Green-shoot crowd was last seen dancing in the streets as a result of this news. 

I am quite certain this is no reason to sing and dance; weeping would be a more appropriate course of action.  People that lost their jobs a while back are running out of time on their (even extended!) benefits.  This is not a sign of the employment scene improving; it is a sign of masses of unemployed running out of government support.  It is not a surprise that in spite of perceived improvements in economic data and an ongoing rally in stocks, Consumer Confidence started sliding down again in July.  It is also not a big surprise that Spending remains subdued, although no longer falling. 

The housing sector is stabilizing, but continues to have serious issues.  Industrial activity continues to languish as excess capacity remains at record levels.  The US Trade Deficit is still quite large, but the trend there is toward lower levels.  The preliminary report for the Second Quarter economic activity indicated a decline of 1%.  This was slightly better than forecasts of -1.5%, however the Q1 GDP was revised down from -5.5 to -6.4%.  The inflation component dropped sharply from 1.9 to 0.2%; leaving the nominal GDP Figure in solid negative territory again at -0.8%.  In Canada, the employment scene is still decaying, our trade balance is setting new deficit records and economic activity is declining faster than the experts are expecting.  It is only natural that the weakness on the fundamental front in Canada is causing the Canadian Dollar to continue to advance toward par (?).  This week’s schedule will include the ISM Purchasing Managers’ surveys, data on Personal Income and Spending as well as the monthly Employment report.

INFLUENCES:  Trader sentiment surveys were steadily ticking higher and they got back to neutral territory half way through July.  This past week positive sentiment toward bonds actually faded somewhat.  I expect sentiment to be somewhat supportive going forward as there is plenty of room before this metric becomes overdone.  The Commitment of Traders reports showed that Commercial traders were net long 433k 10 year Treasury Note futures equivalents – an increase of 90k from the end of June.  This is positive.  Seasonal influences are positive for a couple of days, before turning down into mid-month.  The technical picture is improving as bonds were chopping sideways to higher in July.  I expect that we should get further follow through to higher prices in the long bond during the weeks ahead.

RATES:  The US Long Bond future moved up ½ point to 119 even, while the yield on the US 10-year note decreased 6 basis points to 3.48% during the month of July.  The Canadian 10 year yield was 6 basis points higher at 3.46%.  The Canada-US 10 year spread shrank 11 basis points to 2.  The US yield curve was flatter as the difference between the 2 year and 10 year Treasury yield decreased 7 basis points to 236. 

BOTTOM LINE:  Bond yields declined in July, while the yield curve became flatter.  The fundamental backdrop remains weak, which is supportive for bonds.  Trader sentiment turned more positive, and it is now in solid neutral territory – which is positive; Commitment of Traders positions are supportive and seasonal influences are bullish.  I recommend keeping the long bonds that were purchased back in June.

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

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