Thursday, January 7, 2010

When the Bond Market Goes Boo?


Friday morning at 8:30 a.m. Eastern, traders around the world will all be glued to their Bloomberg terminals eagerly awaiting the release of the first US jobs report of 2010. According to a buddy of mine who trades currencies, Bloomberg's mean consensus forecast is at zero, with estimates all over the map.

"Kind of makes you wonder why we pay these economists big bucks for!", he lamented. He's right, most economists are fence sitters and can't make a call. I laid it all out in my Outlook 2010. I expect huge job gains (even higher than the number posted on Zero Hedge) with substantial upward revisions to the previous reports. I also expect the greenback and crude to rally but gold will get hammered on the news.

Barring some shock, tomorrow's job numbers will likely further jolt the bond market. Matthew Brown and Wes Goodman of Bloomberg report that Treasuries’ 2-10 Year Yield Spread Nears Highest in 20 Years:
The difference between two- and 10- year Treasury yields widened to within 4 basis points of the most in at least 20 years as the Federal Reserve signaled it will hold its target interest rate at a record low.

The so-called yield curve steepened after minutes of the Fed’s last meeting showed officials believe economic growth will be “rather slow relative to past recoveries.” The Treasury will announce plans for next week’s debt sales today.

“Growth and inflation concerns are pushing up longer yields, while market participants are betting that the central bank will keep rates on hold,” said Michael Markovic, a senior fixed-income strategist in Zurich at Credit Suisse.

The 10-year note yield was 3.83 percent as of 8:25 a.m. in London, according to BGCantor Market data. The 3.375 percent security due in November 2019 was little changed at 96 9/32.

The rate is 2.82 percentage points more than two-year securities. The spread was 2.84 percentage points earlier today, within 4 basis points of the biggest gap since at least 1990. The curve widened to a record 2.88 percentage points on Dec. 22.

The government will sell $10 billion in 10-year Treasury Inflation Protected Securities on Jan. 11, $40 billion of three- year notes on Jan. 12, $21 billion of 10-year securities on Jan. 13 and $13 billion of 30-year debt on Jan. 14, according to Wrightson ICAP LLC, an economic advisory firm in Jersey City, New Jersey.

Growth Indicator

The spread indicates the chance of a U.S. recession by year-end is “very low,” according to a report Jan. 5 by Joseph Haubrich and Kent Cherny, researchers at the Fed Bank of Cleveland.

A steep curve indicates strong growth and a flat one suggests a weak expansion, the report said. A sloping yield curve gives banks incentive to borrow at short-term rates and make longer-maturity loans, providing stimulus to the economy.

The three-year sale amount estimated by Wrightson ICAP would match the most ever, while the rest of the auctions would fall short of records.

Fed officials discussed whether the economy is strong enough to allow their $1.73 trillion of asset purchases to end in March and differed over the risk of inflation, minutes of their last meeting showed.

Differing Opinions

A few policy makers said it “might become desirable at some point” to boost or extend securities purchases aimed at lowering mortgage rates, while one person sought a reduction, according to minutes of the Dec. 15-16 meeting of the Federal Open Market Committee released in Washington yesterday.

On inflation, some officials said slack in the economy will damp prices, and others saw risks from the central bank’s “extraordinary” stimulus.

The Fed is buying $1.25 trillion of mortgage-backed securities issued by housing-finance companies Fannie Mae, Freddie Mac and federal agency Ginnie Mae. The central bank began the program in January 2009.

The central bank separately purchased $300 billion of Treasury securities from March through September 2009 and is buying, through March, $175 billion of corporate debt issued by government-backed Fannie and Freddie and the government- chartered Federal Home Loan Banks.

‘Extended Period’

Fed policy makers maintained a pledge to keep interest rates low for an “extended period” following their meeting on Dec. 15-16. The promise is helping anchor yields on two-year notes, which tend to track the central bank’s target for overnight lending because of their short maturity.

The Fed is targeting a range of zero to 0.25 percent for overnight loans between banks.

The likelihood of a raise is rates at the Fed’s June 23 meeting fell to 24 percent yesterday in New York, according to Federal Funds Implied Futures. The probability was 41 percent a week ago.

The difference between yields on 10-year notes and Treasury Inflation Protected Securities, or TIPS, a gauge of trader expectations for consumer prices, widened to 2.41 percentage points, within 2 basis points of the most since July 2008.

Inflation will be “fairly low” in the U.S. this year, said Bob Doll, chief investment officer for global equities at BlackRock Inc. in New York, the world’s biggest money manager with about $3.2 trillion in assets. American stocks will outperform cash and Treasuries, he said on Bloomberg Television yesterday.

Susanne Walker of Bloomberg reports that U.S. Breakeven Rate Reaches 18-Month High on Growth, Inflation:
The gap between yields on U.S. 10- year notes and inflation-indexed debt reached the widest since before Lehman Brothers Holdings Inc. collapsed as investors bet that consumer prices will accelerate as the economy strengthens.

The breakeven rate on 10-year Treasury Inflation Protected Securities, or TIPS, increased as much as six basis points to 2.46 percent, the widest since July 2008, as the U.S. announced it will sell $10 billion of the debt next week. Yields on other government securities were little changed before a report tomorrow forecast by economists to show that the U.S. didn’t lose any jobs for the first time since December 2007.

“There’s some worry about how we absorb the supply and some are worried about inflation,” said Lawrence Dyer, an interest-rate strategist in New York at HSBC Securities USA Inc., one of the 18 primary dealers that trade with the Federal Reserve. “Even if you are bullish about the long-term rates outlook, you don’t want to buy cheap bonds that will get cheaper, so people have limited risk appetite.”

The breakeven rate, which rose from 0.04 percent in November 2008, shows the improving economy may change sentiment and spark further losses in bonds. Yields on the benchmark 10- year Treasury note hit 3.91 percent last week, the highest level since June.

Move ‘Sooner’

Policy makers are considering how to exit from unprecedented stimulus and emergency credit programs amid signs the U.S. economy is rebounding.

Fed Bank of Kansas City President Thomas Hoenig said the central bank should move “sooner rather than later” to reduce stimulus, with a goal of eventually boosting the benchmark interest rate to “probably between 3.5 and 4.5 percent.”

“Maintaining excessively low interest rates for a lengthy period runs the risk of creating new kinds of asset misallocations, more volatile and higher long-run inflation, and more unemployment -- not today, perhaps, but in the medium- and longer-run,” Hoenig, who votes on monetary policy decisions this year, said today in a speech in Kansas City.

U.S. regulators including the Fed warned banks to guard against possible losses from an end to low interest rates and reduce exposure or raise capital if needed.

So how long will the Fed stay on the sidelines? There too, economists are all over the map, but the majority see no rate increases before the end of the year:

More than 80% of economists participating in the Blue Chip survey believe the Fed will begin to raise the federal funds target rate by the end of this year, with the first increase not coming until late September or early November. The target is now at a record-low level of 0% to 0.25%.

The key remains a healthy labor market, Gertler said. "It is hard to imagine anything changing until there is positive and robust employment growth," Gertler said.

The Fed could tighten with the unemployment rate high but not if employment growth is not sustained, he said.

Ideally for the Fed, the bond market would start to gradually push interest rates higher allowing the central bank to follow behind.

Dean Maki, chief U.S. economist at Barclays Capital Inc., predicts the Fed will tighten in September.

The "extended period" language will be changed "at one of the next few meetings," Maki said, maybe even at the bank's next meeting on Jan. 26-27.

Glassman at JPMorgan Chase doesn't think the Fed will tighten for the next two years. "Nothing in the way they describe the outlook makes you think they believe it is time to get moving," Glassman said.

The economy will be too fragile this year and the Fed will be reluctant to tighten in 2011 because the federal government is likely going to try to get the budget on a sustainable path, leading to the biggest fiscal adjustment ever, Glassman said.

My views are mixed. On the one hand, given the pension crisis and the fragility of the financial system, I believe the Fed would rather err on the side of inflation instead of risking a deflationary episode. They will try to keep a steep yield curve for as long as they possibly can, allowing banks to repair their balance sheets and trade in all sorts of risk assets.

On the other hand, robust figures in the labor market will shift market expectations, forcing the Fed to react sooner rather than later. So the big surprise in 2010 will come if the Fed starts raising rates in the second half of the year.

On that note, hold on to your hat, the bond vigilantes will be out full force on Friday. And when the bond market goes 'boo', its chill will be felt across all asset classes.

***UPDATE: US sheds 85,000 jobs in December***

BOO! U.S. employers unexpectedly cut 85,000 jobs in December, government data showed on Friday, cooling optimism on the labor market's recovery. Need to check revisions to previous reports, but I still expect hiring to pick up significantly in the first quarter.

***Read my follow-up reply on why there is still scope for optimism on U.S. jobs.

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