US Treasury Bond Market Outlook

By: Levente_Mady

The Treasury market managed to make it 2 positive weeks in a row even in the face of a stronger stock market.

Last week it was Fannie Mae and Freddie Mac's turn to report losses that were out of this galaxy. Both of those stocks are now trading comfortably under $10 per share, but the Administration still maintains that there is no bailout necessary to save these mortgage behemoths. Credit spreads remain under pressure and liquidity is not improving. The Wall/Bay street analyst community is slow to react but the torrent of downgrades keep poring in as a result. On-going problems on this front are likely to support the bond market.

The Treasury conducted a couple of quarterly refunding auctions: 10 year notes on Wednesday and 30 year bonds on Thursday. The auctions were both very well received by both domestic and international investors. As a matter of fact, the 10 year Note was so aggressively bought that the bond market rallied strongly into the 30 year auction. The other event of some significance was the FOMC policy meeting last Tuesday. As expected, the Fed left its overnight rate unchanged at 2%. As per my previous comments, 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. In addition to the Fed meeting, a couple of European Central Banks held policy meetings as well on Thursday.

Both the ECB and the Bank of England acknowledged that the European economies have slowed considerably and they have no immediate plans to raise rates at this point. The US Dollar had its best week in years in reaction to the dovish chatter from Europe 's leading central bankers. Add to the pile the weak economic reports coming out of even countries that have resource based economies such as Canada and one gets a picture of a significant slowdown not only in the USA but also across the rest of the globe. As a result a number of bond markets are now discounting further Central Bank rate reductions. In Canada for instance, the Central Bank Rate is 3%, but the 2 Year Bond Yield last traded at 2.72%, indicating that in the bond trader's opinion the Bank of Canada rate is artificially high and it should be lowered sooner than later in spite of the concerns expressed about inflationary pressures after the last couple of BOC meetings.

NOTEWORTHY: The economic data was mixed again but only relative to expectations last week. The U.S. Consumer continues to defy gravity! Personal Income increased 0.1% while Spending was up 0.6% in June. In case you wonder how that can happen, the answer is also in last week's economic data: Consumer Credit jumped another $14.3 Billion in June. I can't help but wonder how much longer this trend will sustain itself. I don't have the answer for that, but one thing I am sure of: when it stops, it will be very ugly. Weekly Jobless Claims ticked up another 7k last week to 455k. This followed a week where claims exploded 44k. That is terrible news on the employment front. The monthly unemployment report in Canada was even more disappointing. The Canadian economy lost 55k jobs in July which was way below expectations of a small 5k gain. The Unemployment rate fell from 6.2 to 6.1% due to 74k leaving the workforce. Next week's headliners will include the Trade Balance, Retail Sales, CPI, Capacity Utilization, Industrial Production and preliminary figures for the Michigan Consumer Sentiment report.

INFLUENCES: Trader surveys remained neutral on bonds during the latest week. Bullish sentiment ticked down a couple of points for the first time in a few weeks. The Commitment of Traders reports showed that Commercial traders were net long 431k 10 year Treasury Note futures equivalents – an decrease of 27k from last week. This is providing the bond market with a decent tail wind. Seasonals are 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 another half point to close at 116-12, while the yield on the US 10-year note was unchanged at 3.93%. 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 1 basis point to 143 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 neutral but COT positions as well as seasonal influences are supportive 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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