US Bond Market Outlook- Treasuries Cheap Relative to Stocks

By: Levente_Mady

The Treasury market was pretty much flat last week. The Fed dutifully lowered rates by 25 basis points to 2% as the market expected on Wednesday. The brave men on the FOMC actually came up short on declaring a neutral bias, but the markets pretended that they were close enough to act as if the financial crisis was just about over. We got the seasonal pressure that we were looking for in bonds again this year.

However that time window is closing and with stocks recovering nicely even the completely useless Fed model shows that 10 Year Treasuries are 1.5 standard deviations cheap to equities right now. We might get a little cheaper in bond land this week as we head into the 10 year and 30 year Treasury auctions, but if I was a betting man, I would be looking to get a little long the bond market and perhaps sell some stocks against that long bond position.

NOTEWORTHY: The economic data calendar was very peculiar last week. The Conference Board Consumer Confidence survey just confirmed what we already knew from the Michigan Consumer Confidence survey: the consumer is lying flat on its back, looking for a good looking rock to crawl under. Advance Q1 real GDP was reported at +0.6%. That is anemic growth at best. I like to look at the nominal figure - and the trend in it – as it filters out some of the quarterly noise caused by the short term fluctuation in the deflator. This was the second quarter in a row with nominal GDP within a whiff or 3%. Now some could make the point that with CPI north of 4% for the past 6 months, it leaves real GDP well short of flat, but far be it for me to stick my neck out and suggest anything like that. Weekly Jobless Claims increased 35k to 380k last week.

Auto Sales – like the housing sector – continue to deteriorate. Personal Income increased less than forecast, while Spending increased more than expected. Miraculously Spending growth outpaced Income growth again in March. The ISM Manufacturing index remained below 50 at 48.6. This survey forecasts ongoing weakness in the manufacturing sector.

The monthly Employment report was quite misleading. If the reader is interested in a detailed analysis, I suggest that he/she check Baron's or try and get a copy of the great work that is done by the good folks at the Liscio Report. The bottom line is that even if we take the report at face value (which is quite difficult to do) and pretend that non-farm payrolls only declined 20k, that is still close to 200k below the +175k or so jobs that need to be created to keep up with demographic trends and have the economy just tread water. That is close to 2.5 million jobs per year that are lost/not created at the present pace.

I am going to reiterate what has been a recurring theme in this commentary: The consumer is well over 70% of the US economy. The consumer is in horrid financial shape already, but seems to still find ways to stay afloat. Increasing job losses will severely impair the consumer's ability to find sources to finance past spending trends. The real economy is in real trouble and it ain't turning around any time soon. Next week's headliners will include the Purchasing Manager's Survey for the service sector, Pending Home Sales, Consumer Credit and the Trade Balance.

INFLUENCES: Trader surveys were slightly optimistic on bonds during the latest week. The present levels are in neutral territory. The Commitment of Traders reports have indicated that the commercials have a long bias in their positioning. Last week's data indicated that Commercial traders were net long 374k 10 year Treasury Note futures equivalents – an increase of 24k, which is supportive for the bond. Seasonals remain negative for a few more days, but they will be turning positive soon. The 10 year yield leveled off near 3.85%. I expect support in the 3.9 to 4% area to hold for now.

RATES: The US Long Bond future traded up marginally to close at 116-07, while the yield on the US 10-year note decreased 2 basis points to 3.85%. The yield curve was flatter, but I am expecting that the curve will soon resume steepening. 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 moved down 6 bps to 140 during the past week. It looks like the curve steepener has run into solid resistance at the 200 level. This may take months to overcome. In the mean time the range is expected to be 140 to 200.

CORPORATES: Corporate bond spreads rallied sharply. 10 year bank sub-debt never quite made it past 300 as it was reported here last week; the widest it got was about 280. That spread was closer to 240 by the end of the week. I recommended shorting the bank sub-debt issue at Canada bonds +58 basis points a while back. A couple of weeks ago I recommended that accounts review their short exposure and fine tune it somewhat by covering half the short position. As per the comments above, I don't think we are out of the woods yet on fixed income spread product yet. We are seeing record corporate issuance across the spectrum. New product is well received and it is narrowing in. I hope this temporary recovery has a bit more strength, so we get a chance to reset the shorts we covered last month.

BOTTOM LINE: Bond yields tried to drift lower, but moved back to unchanged for the week on Friday. The fundamental backdrop remains bleak as the economic data just keeps getting worse. Trader sentiment and seasonals have been negative but are moving to neutral, while the COT positions are supportive. My recommendation is to add to the curve steepener, continue to shun the weaker corporate credits. Silly as it may sound, I liked the 2 year note yield at 2.25% and I like it even more at 2.45%.

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

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