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Professionally Speaking
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Bond Market Commentary by Mike Petersen
A Summer of Discontent
By Zach Berg
August 30, 2010
As August comes to a close and Labor Day approaches, the end of a precarious summer is upon us. Entering the season months ago, investors were more optimistic after the European crisis seemed to have abated and earnings season approached with overwhelming successful bottom line figures. However, now as summer draws to an end, the economic data has turned sour leading to a noisy market, in which the fragility of the economy is debated constantly. This past week, the discontent of the markets was on full display after extremely disappointing new and existing home sales figures, coupled with a poor reading on business equipment investing sent 10-year Treasury yields below the psychological 2.5% level. The stay below 2.5% was brief, as the rally across the curve was fueled in large part by a growing belief that Bernanke would announce further quantitative easing (QE) at the Jackson Hole symposium. Instead, Bernanke’s statement introduced no new policy measures, but rather outlined the methods the Fed could take to stem a further decline in the economy. Included in the potential measures were: more purchases of Treasuries, pledging to keep rates lower for an even longer extended period, and paying less interest on reserves. The dovish tone of the statement triggered a sell off across the Treasury curve leading to a three-point sell off on the 30-year note and leaving rates slightly higher on a week over week basis. Even though some investors may have become overzealous in their idea that the Fed would announce new QE less than two weeks into QE “lite,” Bernanke’s breakdown of the possibly remedies leaned towards further QE as the most likely measure to be taken. As economic data continues to pour in, further weakness in the figures will likely keep the QE bid in for Treasuries, and in turn keep yields near their recent lows.
Where’s the demand for Treasuries coming from?
With the Fed embarking on their recent bout of QE in the 2-10 year area of the curve (purchasing $8.8 billion thus far) the forcing of investors out on the yield curve, which was detailed two weeks ago in the bond market commentary, appears to have already begun. The yield curve has bull flattened significantly during the summer months, as investors have been forced to extend their duration in search of yield with longer term Treasuries. Thanks to the Fed’s recent action, this move is becoming more pronounced and is leading to the strong bid in the long-end. To illustrate, the chart below details the Treasury purchases of foreign investors in the 3-year, 10-year, and 30-year notes as a percentage of the total issuance of the auction. The graph clearly depicts foreigners increasing demand for longer maturities, especially in the 10-year note, as they have increased their participation from around 10% in May to over 30% during the past auction.
Among those foreign investors increasing their purchases of US Treasuries, the Japanese have perhaps been the most active in the markets. For a Japanese investor, the prospects of a 2.6% 10-year UST is rather attractive when compared to a 10-year Japanese note trading at roughly 1% for the first time since 2003. In addition, similar German Bunds trade at 2.2% and French notes at 2.5%, making the US paper attractive versus European alternatives. The chart below highlights this increasing demand, as Japanese investors are increasing their purchases of foreign bonds to new highs during the past month of August. With Japanese yields likely to remain low during the upcoming months, this demand source for Treasuries is likely to continue as well.
The Week Ahead
The continuation of last week’s late sell off in Treasuries will be put to the test this week as the markets digest a plentiful amount of new economic data. On the under card for the week includes: personal income and spending, S&P Case Shiller, FOMC minutes, ADP employment, factory orders, and pending home sales. All of these will lead up to the main event on Friday, with the release of the extremely vital employment report. The consensus via Bloomberg is calling for a loss of 100,000 in nonfarm payrolls, a gain of 47,000 in private payrolls, and a slight uptick in the unemployment rate to 9.6%. In addition to the economic data, the FDIC will hold its quarterly banking briefing, in which it will reveal how many banks are on its “troubled bank list.” Given the bevy of data and with many investors enjoying one last week of vacation, the summer of discontent is likely to persist into the Labor Day holiday.
A Little Food for Thought...
Corporate Spreads and the Equity Markets
After a stellar earnings season for company’s bottom lines, the recent risk aversion brought on by “double-dip” fears have led corporate spreads wider. As one would expect, the recent direction of spreads has been largely correlated with the broader moves in the equity markets, as the graph below displays.
With the correlation between spreads and the equity markets established, we look at various dates during the past three years for data points on corporate spreads and the S&P 500. The diagram below highlights various points and the corresponding figures for the S&P 500, Bloomberg 10-year composite A-rated index curve, Bloomberg 10-year composite BBB-rated index curve, and the 10-year Treasury note.
The importance of the dates:
- 10/9/2007 – Peak in the S&P 500 Index
- 10/6/2008 – S&P 500 declines to similar level as to where the market is today, representing a 33% correction from peak
- 12/30/2008 – 10-year Treasury note reaches low of 2.053%
- 3/9/2009 – S&P 500 bottoms out during current recession at 676.53
- 9/15/2009 – S&P 500 regains similar 1052 level as today
- 4/23/2010 – 2010 S&P 500 peak
A few takeaways from the data:
- The figures reiterate the extremely low yield environment investors find themselves in today when compared to other recent points in time.
- Although corporate spreads have tightened dramatically over the past 21 months, they still remain slightly wider when compared to the peak of the equity markets in 2007.
- With “double-dip” fears a concern, the markets would likely need a significant market shock to send spreads careening wider. Consider that at current levels, if the S&P 500 were to decline nearly 16% as it did from 10/6 – 12/30, a similar move in corporate spreads would only amount to a widening to 231 bps for A-rated and 348 bps for BBB-rated bonds.
Although equity indices and corporate spreads are highly correlated, it is important to note that there are other factors to keep in mind when examining the relationship for corporate spreads. More importantly than a predictor of future spreads, the chart is a reminder of the path rates have taken to reach this point in time. Currently, the rebalancing of companies to strengthen their balance sheets is a key difference to the leverage employed during 2007. This rebalancing together with current spread and yield levels makes the possibility of the blowout levels of the past an unlikely outcome for the future.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.
The Running of the (Flat) Bulls
By Benjamin Streed
August 23, 2010
The 10-year Treasury note headed higher for a fourth week in a row last week, the longest weekly run-up in prices since February. The yield on the 2-year note fell to a record low 0.4796%, while the yield on the 10-year is the lowest since March 2009. It should be noted that 2-year rates tend to track the Fed’s target for overnight lending due to its shorter tenure, while the 10-year is more closely tied to the size of government debt and inflation expectations. According to Bank of America/ML Treasuries have returned 8.2% YTD for 2010 after a decline of 3.7% last year, stoked by investor demand for safe assets as equity indices fell. Fueling the decline in yields is investor fear regarding the potential for a dreaded “double dip” recession as economic data continues to arrive below expectations. On Friday, the Philadelphia’s economic index figure surprised the markets only one day after unemployment claims arrived showing a trend upwards in initial jobless claims. The poor menu of economic data continued to stir the market’s doubts and resulted in a further bull-flattening of the Treasury curve. This happens when longer-term rates decline faster than shorter-term rates.
Lucky Number 777
U.S said on Thursday that it plans to auction $102 billion of two, five, and seven-year notes next week, which is the smallest monthly offering of this combination since May 2009. The Federal Reserve, via its pledge to roll its mortgage securities into Treasuries, purchased a whopping $6.16 billion last week. The main motive behind this plan is to attempt to kick-start the lethargic U.S. economy by keeping borrowing costs low. This week the purchases continue with the Fed planning to purchase notes with expected maturities from 3 to 30 year within the ranges of 2013 to 2014, and 2021 to 2040. By the middle of September, the central bank is expecting to have purchased $18 billion of U.S. debt using the money from principal payment from its holding of agency debt and agency mortgage-backed securities. The Fed currently holds $777 billion in U.S. Treasuries and is forecasted to increase this amount by roughly $30 billion per month. At this rate, the Federal Reserve will surpass Japan, the world’s third largest economy and third largest holder of Treasuries by the end of September. China, which recently surpassed Japan to become the world’s second largest economy, sits on a mere $40 billion more than Japan, indicating that the Fed could become the number one holder of U.S. Treasuries in time for the mid-term elections in November.
Something to Keep Your Eyes On: The New “Conundrum”
There is an ongoing trend between Treasury yields and stocks in which they move in tandem. As stocks move upward, yields tend to follow suit and when stocks decline, yields do the same. Currently, the stocks, as measured by the MSCI World Index, have diverged from this historical trend and are currently rising during a period when bond yields continue to decline. There have been eight such occurrences in the past, and in 5 occurrences stocks continued to rally eventually forcing yields to move higher (bond prices moved lower). Unfortunately for stock gurus, many economists foresee that this time is different, and yields may fall further before eventually rising at an indefinite time in the future.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.
Break in Case of Emergency
By Zach Berg
August 16, 2010
The Federal Reserve sounded the alarm bells this past week after deciding to alter their current policy by placing a floor on the amount of assets held on the Fed’s books. The result of not allowing maturing agency and mortgage back debt to roll off the balance sheet is a second bout of what can be described as quantitative easing (QE) “light.” Although this go-round is more symbolic in nature, the Fed’s change is a clear sign that they are indeed concerned with what appears to be a faltering economic recovery. The change in the FOMC statement on Tuesday sent Treasury rates lower, especially in the intermediate and longer dated maturities. However, unlike the first QE program in March of 2009, Treasury yields did not move lower nearly as much following the announcement from the Fed, as the graphs below depict.
Another key difference this time around is the amount of debt the Fed intends to purchase. Unlike the first QE program in which the Fed targeted $300 billon (bln) in Treasury debt, this episode has no clear-cut amount to focus on. Estimates range from $200-$400 bln from firms such as Bank of America/Merrill Lynch, but the exact amount is difficult to pinpoint due to the varying prepayments of the mortgage back debt. Although $400 bln sounds like a very large figure, when one considers the Treasury is on pace to issue nearly $2 trillion in debt this year, the prospect of the Fed purchasing 10-20% is a relatively small incursion into the markets. In addition to the size of the purchases, the maturities the Fed targets will have significant implications for the shape of yield curve. The Fed has already stated that they will concentrate their purchases in the 2-10 year area keeping the same focus point as before. During 2009, the Fed favored the 2-5 year maturities, purchasing a little over $139 bln which equates to over 46% of their total purchases.
In an attempt to avoid causing too much distortion to the yield curve, the Fed is likely to spread its purchases out across the 2-10 area. However, with 2-year rates setting daily record lows for yield levels, the largest bang for the buck may come from purchases further out the curve.
As the Fed attempts to stimulate the economy and move investors out on the risk spectrum, there will certainly be ramifications for the fixed income markets. With yields already at unbearably low levels for many investors, consider that during the Fed’s first announcement of QE in 2009, it took nearly a month and a half before Treasury yields returned to levels last seen prior to their policy change. Also important to consider is that during that time period, the US Economy was producing increasingly positive figures, unlike what is occurring at the moment. Using the March data as a proxy and combining the weakening economic data, it is not unrealistic to expect low yields for an even longer protracted period. The notion of the Fed on “perma-hold” is reflected below in the charts that compare various economists’ projections for the Fed Funds rate from June to August.
In addition to the low yield prospects, the Fed’s purchasing of Treasuries will have implications on both the shape of the yield curve and the relative value of assets based off of the curve. With the Fed concentrating in the 2-10 year window, it is likely that the 2-5 year and 2-7 year portions of the curve will bull flatten. If the Fed does indeed concentrate in the intermediate maturities, the longer 10-30 year curve may continue to remain steep in comparison to shorter maturities. As a result of the change in the yield curve shape coupled with a longer time horizon for a Fed rate hike, investors may well be pushed out on the curve in the search of yield. One item that is certain is that the Fed is using all of its tools at its disposal to attempt and prevent the US economy from going up in flames.
A Little Food for Thought...
Trader’s Positioning
This week’s food for thought focuses on the Commitment of Traders Reports (COT) published by the Commodities Futures Trading Commission (CFTC). This report breaks down options and futures contracts currently open on various exchanges. The chart below shows the percentage of traders who are bullish for the Chicago Board of Trade 2-year and 10-year note and for the Chicago Mercantile Exchange S&P 500 contract. These figures are only for traders who are making speculative bets on these particular contracts and are not using the options or futures as hedging instruments. Although the data can be extremely volatile, as one would have expected, Tuesday’s Fed action led many traders to switch their stance on 10-year Treasuries to reflect the Fed’s new operations. It also displays the uneasiness of whether or not the new Fed policy will aid the equity markets in the near term.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.
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