Fundamental Backdrop Remains Supportive of Treasury Bonds

By: Levente_Mady

The bond market crept up toward the middle of the 118 to 124 trading range of recent months as per our advertisement in last week’s issue.  3 month Treasury Bills are back to negative yields again heading into the year end, just like last year.  While 3 month Bills are back under 0, the swap market is telling us that sovereign risk is on the increase.  Credit Default Swap spreads for most of the largest developed nations (think G7) have widened noticeably over the past few weeks.  With the front end literally at 0, it looks like long rates will dictate the shape of the yield curve for the rest of the year. 

We all know how the bond market rallied about 20% from mid November to the end of the year in 2008.  With Bills back under 0%, the potential appears to be there for a similar trade again in 2009, but before I jump on that bandwagon, I would like to see the Long Bond Futures close and hold above 124 – the long bond ETF is TLT and a key equivalent there would be 98.

There is one topic that I got wrong this year: China.  It has been irritating, so while not immediately relevant to bonds right now, I just wanted to spend a few lines in the topic.  Since China has an export based economy, I expected it to grind to a halt and suffer due to a collapse in demand for its exports.  While the demand for exports has collapsed as expected, China’s economy continues to grow at near double digit rates.  “How is this possible?” one may ask?  Simple: rampant credit growth.  Apparently credit thus far in 2009 exceeded 2008 levels by about 130% causing money supply to increase by 30% this year.  China’s Debt to GDP ratio has gone ballistic and it is near 140% at the last count.  China has a centrally managed economy with a centrally managed currency.  Call it a new bubble or call it what you will, it is also an accident waiting to happen.

NOTEWORTHY:  The economic calendar was quite busy and quite disappointing last week.  Retail Sales bounced 1.4% in October, but they failed to even recapture the downward revised 2.3% decline from the previous month.  Ex-auto Retail Sales were essentially flat at 0.2%.  The economy is certainly not getting any help from this data series.  Based on the close to 1% downward revision of the September data, we can anticipate a revision lower of the Q3 GDP data.  The NY State Empire Manufacturing Index dropped from 34 to a lower than forecast but still respectable 24.  Industrial Production and Capacity Utilization was a snick stronger but weaker than expectations. 

On the inflation front, producer prices increased significantly less than forecast (due to a sharp drop of 0.6% in the core components), while consumer prices increased slightly more than forecast (0.3% vs. 0.2% expected).  The blockbuster data last week had to be Housing Starts.  Economists expected further improvement from 592k to 600k, but they got a sharp drop to 529k instead.  Building Permits also dropped from 575k to 552k.  With Builder Sentiment stuck near record lows at 17 (on a scale of 0-100) all is not well on the housing front. 

Weekly Initial Jobless Claims were unchanged at an upward revised 505k last week.  The Philadelphia Fed Manufacturing Sentiment Index was the lone bright data point last week as it increased 4 points to 16 and managed to beat expectations of no change.  Leading Economic Indicators improved 0.3% in October.  The Canadian consumer prices increased more than expected despite ongoing strength of the Canadian Dollar.  Core CPI is back to flat after a 0.4% seasonally adjusted increase in October, while the core CPI increased 1.8% - up from 1.5% - through the past 12 months.  This week’s economic schedule will be very busy before the market shuts down for the US Thanksgiving holidays on Thursday.  The data will be highlighted by Home Sales, revision to last quarter’s GDP data, Consumer Confidence reports, Personal Income and Spending data and the Durable Goods Orders report.  The market will also be looking at another short Treasury auction cycle (2-5-7 year notes) Monday through Wednesday.

INFLUENCES:  Trader sentiment surveys were unchanged last week.  On a scale of 1-10, the surveys I follow are just a shade above dead neutral at 5.5.  I expect sentiment to be somewhat supportive going forward as there is plenty of room to rise before this metric becomes overdone.  The Commitment of Traders reports showed that Commercial traders were net long 343k 10 year Treasury Note futures equivalents – an drop of 88k from last week. 

This metric is slightly supportive for the market.  Seasonal influences remain positive here as well.  The technical picture is neutral, but I am still comfortable with a slight positive bias and a range of 118 to 125 to hold here.  We are in the middle of the range and anticipating further improvement.  We remain slightly long the bond market as we just rolled a short put position on the Long Bond future.  With a number of our indicators in no man’s land, we are content to stay close to neutral and earn some cash through time decay.

RATES:  The US Long Bond future moved up 1½ points to 120-28, while the yield on the US 10-year note decreased 6 basis points to 3.36% last week.  The Canadian 10 year yield dropped 9 basis points to 3.38%.  The Canada-US 10 year spread was slightly narrower at 2 bps in favour of the US.  The US yield curve was slightly flatter as the difference between the 2 year and 10 year Treasury yield faded 1 bp to 264.

BOTTOM LINE:  Bond yields dropped in all maturities last week, while the yield curve was essentially unchanged.  The fundamental backdrop is supportive for bonds.  Trader sentiment is neutral; support provided by the Commitment of Traders data is positive and seasonal influences are positive as well.  While most of our indicators are in neutral territory, the fundamental backdrop supports our positive bias for the bond market.

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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