Fundamentals

Treasuries Rally Tempered Growth Forecasts Offset Supply Glut

US Treasuries

• G8 Keeps the Focus on Financial Stability, Off the Dollar’s Reserve Status
• Record Treasury Sales Threaten US Debt’s Global Appeal

Treasuries Rally Tempered Growth Forecasts Offset Supply Glut

US 10-Year Treasury Note                3.852          -26bps (MoM)

Treasuries have marked a sharp reversal over the past month; and fundamentals would help catalyze the reversal. The advance that began back at the 114 low set on June 22nd has so far been the most progressive advance in the benchmark 10-year note since before the bull wave ended at the turn of the year. Looking at more chart data, we can see that this is still a correction in a larger decline. However, there is enough fundamental support to extend this advance on to a genuine trend change.

Through the gradual appreciation in Treasury yields over the first six months of this year, there has been very little improvement in economic forecasts. While there have been modest upticks in various, short-term economic indicators, these developments have yet to translate into national expansion. Annualized growth in the world’s largest economy was an annualized 5.5 percent through the first three months of the year. And, for those commentators hanging their hat on more timely data: the unemployment rate is at a 26-year high 9.5 percent; business activity is still contracting; and credit is still being held up at the bank level. The markets are naturally a speculative space; and forecasts for an eventual recovery will naturally be reflected in price action. However, a distant turn to positive growth and the threat of a double bottom or ‘L’ – shaped recovery is an undercurrent that cannot be fought for long.

Looking over the coming weeks, there will be a building wave of fundamental stress on the Treasury market. For growth, the advanced reading of second quarter GDP is due at the end of the month. This is a critical reading that will provide straightforward evidence as to whether the US can expand by late 2009 / early 2010 or the nation’s recuperation will be more arduous than policy officials and market participants had expected. Another, gradual driver for sentiment (and thereby demand for the safe haven Treasury) is earnings season. On one hand, concerns over the health of the financial sector and credit market will call attention to accounting figures for key financial players. Among the banks to release this week are Citigroup, Bank of America, BB&T and JPMorgan. Goldman Sachs has already reported record earnings just a month after paying off its TARP loans. This will no doubt raise political ire while most other firms and sectors suffer current economic conditions. The more general concern for earnings is for a sense of economic health from the business viewpoint. Sales, costs, orders and employment are essential components for growth in this large component of broader domestic production.

Another, factor that should not be overlooked is sheer supply. As the outlook for growth fades, we have seen demand pick up for government debt; but eventually, we will reach a natural limit on capital to sop up an ever increasing supply. The Congressional Budget Office projects the national budget deficit will quadruple to $1.85 billion by next year. So far, record auctions have been met with equally historic demand on high bid-to-cover rations; but eventually capital flows will run dry. This is especially true if other, large economies experience a quicker return to growth while floating smaller levels of debt (like the Euro Zone expects to do). Even longer term, if the US can’t reduce its shortfall relatively quickly, problems like healthcare, an aging demographic and still-excessive levels of leverage could eventually threaten the country’s solvency.

European Government Bonds

• BoE Announces it Will Reduce The Size of Its Weekly Gilt Purchases
• Will Eastern Europe Banks Spark a Financial Seizure and Bund Rally?

When Can European Officials Start Discussing Government Withdrawal?

UK 10-Year Government Bond (Gilt)                            3.840           -19bps (MoM)

While government debt in the US, Europe and Asia mark sharp rebounds, UK gilts have merely turned to consolidation over the past month. Where pressure for Prime Minister Gordon Brown to call a national election have eased, speculation for monetary policy and growth forecasts have filled in. Forecasts of an economic recovery towards the end of this year and into the beginning of next year seem to be universal. However, speculation for the United Kingdom has held stubbornly depressed. When the IMF released its updated growth outlook for the next two years, the promising numbers helped buoy consistently pessimistic market participants. In line with the world-wide turn in output, the global financial regulator predicted a 4.2 percent contraction through 2009 (a slight reduction from the 4.1 percent projection in April); but the outlook for 2010 was upgraded from a 0.4 percent decline to 0.2 percent expansion. Absolute demand for risk-free assets is a product of global sentiment; but the Gilt would further find a relative pickup in demand over the past week from the three-day G8 meeting. Leaders agreed that policy should be focused on fiscal sustainability and economic recovery rather than implementing plans for reducing budget deficits. Another interesting development over the past few weeks comes through speculation over the BoE’s policy stance. At the last meeting, the MPC left the asset purchase plan unchanged at 125 billion pounds. This has initially been taken as a sign that the government is coming to the end of its quantitative easing – though officials have warned investors not to look to deep into this move.

German 10-Year Government Bond (Bund)               3.382            -22bps (MoM)

The outlook for growth and financial health in the Euro Zone is split among its members. Recession is a common denominator for most of the regional economies; but while some are still reeling from the impact of recent record contractions, others are voicing a need to reduce debt and deficits by starting to work down government aid. German Chancellor Angela Merkel is the champion for removing stimulus. It may seem that the G8’s agreement to concentrate on fiscal stability has quieted her resolve; but language surrounding this topic stated the approach that different countries could take towards the eventual exit would vary. This is rhetoric likely tailored for Germany. On the other hand, there are still risks for Europe’s largest economy and its neighbors. Aside from a double dip recession, there is still a threat that Eastern European banks could default and trigger the next financial crisis. This is particularly troublesome for the Euro Zone because many of the region’s banks have not accounted for most of their losses through write downs. In the meantime, we will continue to monitor the economy’s and markets’ progress. The IMF upgraded its 2010 growth forecasts to 0.3 percent expansion and the ECB’s covered bond purchase plan seems to already have borne fruit before it has even been implemented.

Asian Government Bonds

• Prime Minister Aso Calls for a National Election in August
• Japan Looking to Take on Record Amounts of Debt, a Reflection of the Last Lost Decade

Bond Traders Torn Between Improving Growth Outlook and Deteriorating Political Scene

Japanese 10-Year Government Bond (JGB)              1.550             -16bps (MoM)

The benchmark Japanese Government Bond has rallied an astounding 2.5 percent in as short as a month’s time. This has been the most aggressive and consistent rally in prices since before the crisis peaked in September and October of last year. In fact, JGB are on pace to beat their US counterpart for the first time since 1999. This outsized move comes from signs that Japan may once again suffer from yet another ‘lost decade.’ Before the subprime mortgage crisis catalyzed the worst bear market and recession in three generations, the world’s second largest economy was already suffering from a lack of investment and credit. Though it has been over a decade, policy officials have been unable to shake off the effects of the last financial disaster through its failed banking system. Looking ahead, it is clear that the world is not going to see a ‘V’-shaped recovery; which means slow to recover demand in the US, China and other key trade partners could through Japan into an even deeper hole. Such prospects have dimmed even the IMF’s promising outlook for a 1.7 percent pace of growth in 2010 to follow up on the 6.8 percent contraction this year. Adding another facet to the trouble, political uncertainty has been thrown in the mix. A severe plunge in approval has forced Prime Minister Aso to call for a national election next month. The consensus is for a party change for the first time in half a century. Continuity is critical to support a recovery; and changing the rules of the game now may further undermine the struggle to emerge from the gloom.

Treasury Yields Surge as Forecasts of a 2009 Rate Hike Balloon – Is This Realistic?

US Treasuries

•    Fed Approves 10 Banks to Repay TARP
•    International Calls to Abandon the Dollar and Treasuries Growing

Treasury Yields Surge as Forecasts of a 2009 Rate Hike Balloon – Is This Realistic?

US 10-Year Treasury Note      3.226          -8bps
Treasuries may have throttled back on momentum at the start of this week; but the deeply entrenched bearish trend is still in place. Over the past few weeks, the gradual and passive decline in treasury instruments (a rise in yields) has been leveraged by the same shift in risk appetite that has swept over the more speculative asset classes the past three months. The accelerated shift away from risk-free assets back into the open seas of the market reflects the general belief that financial conditions are stabilizing, the pace of recession is ebbing and the Fed is contemplating rate hikes in the near future. This is a volatile mix to support the sharpest drop in the benchmark 10-year T-note since April of 2004; but will the fundamentals pan out to support this reversal in the market’s fortunes?

The most tenuous support for a rebound in risk appetite is what market commentators call ‘green shoots.’ A letup in the pace of pessimism, the contraction in consumer spending, drop in investment spending and so many other critical factors has clearly developed; but an improvement in the pace of recession is not a guarantee of positive growth. An objective review of the data that has come out these past weeks supports the need for caution when making investment decisions. The symbolic thermometer for economic health, the non-farm payrolls release this past Friday marked a far-smaller than expected 345,000 net loss. Nonetheless, this was still a significant loss which finally pushed the total number of jobs losses since the beginning 2008 above the 6 million mark and inflated the jobless rate to its highest level since August of 1983. It follows that consumer confidence is still underwater and all progress made in sentiment is based in forecasts that are perhaps too optimistic with the government’s ability to recharge growth. In the meantime, consumer spending has fallen 10 times over the past 12 months and businesses are still reducing spending and trimming payrolls.

Growth may be the more publicized fundamental driver for risk appetite and the Treasury market; but the stability of the financial markets holds the greater potential for cutting the rally in yields short. With a focus on the eventual recovery in growth, it seems a foregone conclusion that the calm seas since the peak of the crisis back in September/October have ensured risk is no longer a concern. However, even Fed Chairman Ben Bernanke – who is supposed to be a cautious cheerleader for the economy – has warned about the fragile nature of the financial recovery to this point. Record low rates in short-term market and government debt is more a reflection of the artificial liquidity provided by the government than natural supply and demand. In the weeks ahead, the market’s susceptibility to falling back into a fear-fueled diversification into safe-haven assets will rest on the progress of TARP repayments, efforts to improve the public-private investment plan and ill-conceived speculation of a Fed rate hike in the near future. This morning the Treasury approved 10 banks’ plans to raise capital to satisfy a requirement to repay their TARP loans. With much of the capital coming in through the recent rise in risk appetite; there is too much dependency on fickle market sentiment to support a true recovery in the vital financial sector. What’s more, there were notable exceptions from the list of those that were approved, including Bank of America, Citi and Wells Fargo. A far greater concern than unwinding the liquidity offered to banks, is the glut of toxic debt still in the market. Treasury Secretary Geithner’s ambitious public/private plan has garnered interest from well-financed speculators; but the drop in yield has dried the well of acceptable investors. The solution of opening the market doors to other large pools of capital (like insurers and pension funds) merely cycles these toxic derivatives back into the market and raises the potential of another crisis. With these lingering threats and Fed officials weary of the risks, the priced in expectations for a rate hike before the year’s end is premium that will almost certainly be deflated.

European Government Bonds

•    Gilts Reflect Volatility as Political Unrest Interferes With Crisis Management
•    Bund Traders Must Weigh Policy Officials’ Forecasts Against Deteriorating Sovereign Debt Ratings

European Government Bond Yields Rising as Forecasts for Growth Improve, Policy Makers Take Conservative Approach

UK 10-Year Government Bond (Gilt)          3.285         -23bps
While yields on US government paper have surged over the past few weeks; the equivalent Gilts have held relatively stable as the government struggles to put the economy on stable ground. As risk appetite has inflated since the April turn, there has been a controlled diversification away from the UK risk-free paper. From the economic front, there are the same, tentative signs of an economic recovery that have been noted in the US, Euro Zone, China, and even Japan; but the conviction in this catalyzing a true turnaround is lacking. In the past few weeks, data has shown tentative improvements in key sectors. The housing sector has reported a slower pace of contraction in housing prices and the highest level of mortgage approvals in a year. Business activity has similarly improved with the smallest contraction in manufacturing in a year and the first expansion in the service sector in the same amount of time. Even consumer confidence has edge back into positive territory. However, the outlook for growth is still bleak. The IMF pegged the UK economy to the worst recession this year among the industrial nations; and that forecast is not likely to chance with the turn in sentiment measured in the markets recently. This is particularly true should political turmoil heat up. Calls for PM Gordon Brown’s resignation last week forced the administration to reshuffle it ranges. Should Brown or Chancellor of the Exchequer Alistair Darling be eventually ousted, the efforts towards a recovery could be permanently shelved.

German 10-Year Government Bond (Bund)    3.340          -1bps
Like most other government, fixed-income traders the world over, those in the Bund market have followed the unhealthy pace of growth in the asset’s underlying country. However, speculating when the economy will finally turn to positive growth took a back seat to more pressing matters. This past week, the ECB rate decision stirred up interest in yields as market participants were eagerly awaiting confirmation on the central bank’s official stance on monetary policy. In the weeks leading up to the gathering, a divergence in approach was once again developing. The central bank voted to hold rates and keep its covered bond purchasing program at 60 billion euros as expected; but from the rhetoric of the statement and comments of President Jean Claude Trichet, it was clear that the option for easing policy further down the line was still there. Balancing the future of rates as a source of return and a stymie to growth will be a critical fundamental driver in the weeks ahead (especially when policy members decide to air their opinions on what should be done through public forums). However, the health of economic growth and financial markets may have a more pressing influence than speculating on the monthly rate decisions. Despite tentative signs of improved growth, the region is still struggling. This past week, the S&P downgraded Ireland’s debt rating from AA+ to AA and set a negative outlook. Elsewhere, Latvia has been pushed to the brink of crisis and is now working on securing an IMF loan to prevent a bank default that could send waves throughout Europe. This leaves us to wonder: are policy officials forfeiting the advantage of getting ahead of the recession by being so frugal?

Asian Government Bonds

•    Consumers Won’t Be The Catalyst for an Economic Recovery with the Worst String of Earnings Losses Since 2003
•    Business Cut Back on Spending at the Fastest Pace on Records Going Back Over Half a Century

Japanese Officials are Confident The Worst Is Past, But How Long Will the Recession Last

Japanese 10-Year Government Bond (JGB)    1.716           3bps
There is an international effort to benchmark the pace of recovery and recession that each economy is experiencing relative to their major counterparts. Though, regardless of the general improvement in risk appetite and tempered pace of the global recession; the Japanese economy will lag the Western economies. Over the past few weeks, the Cabinet Office and Bank of Japan have joined the crowd by announcing the worst of the recession has passed. This is perhaps an overly optimistic forecast for an economy that just recently printed its worst pace of contraction on record. As we go forward, the health of key sectors will factor in towards establishing the probability of a recovery anytime soon. Recently, capital spending figures for the first quarter plunged the most on records going back over half a century and the output gap (the difference between supply and demand) similarly ballooned to a record. These two issues call to attention the long-term troubles even after headline growth returns. Investment and deflation could weigh on the Japanese markets for another decade as exports and domestic consumption struggle to keep the world’s second largest economy afloat.

Treasuries Remain Buoyant Through Government Purchases And Earnings Season

US Treasuries

• Will the Government’s Stress Test Revive Investor Fears?
• Fed Chairman Ben Bernanke Sees “Tentative Signs” of a Cooling Slump

Treasuries Remain Buoyant Through Government Purchases And Earnings Season

US 10-Year Treasury Note                              3.226       -8bps
Treasuries have held to congestion as global investors are torn between their desire for yield and fear of a persistent recession along with the seizures in financial markets that come along with it. Taking stock of market sentiment over the past month and a half, there has been a tangible recovery in risk appetite. Benchmark equity indexes have risen, junk bond spreads are falling and risk premiums on credit default swaps (among other high-finance products) have tumbled significantly. In the T-notes run up through the past six to eight months, the primary driver was demand for liquidity. Investors desperate to stem the bleeding were diverting capital to the safe harbor of US government debt. Even now, with traders showing interest in putting their capital back to work in the market after an extended period of congestion and uncertainty, we can see that there is still an overwhelming need for safety. Such sentiment is well founded considering fundamentals. While there was room for investor sentiment to recovery from the severely panic-depressed levels following the October market crash, a genuine recovery requires the prospect for a true rebound in expected returns (found through positive growth) and a lasting decline in risk (both economic and financial). These conditions have not been met with many Fed officials warning the public that the recession will likely deteriorate through the summer months and President Obama cautions that unemployment may rise above 10 percent over the same period.

There have been other, more specific factors helping to sustain the T-note’s near record highs. Fading confidence in the G20 meeting on April 2nd has been instrumental in propping up not only US debt; but government paper in most economies. A gathering of policy officials from 20 countries that account for an estimated 85 percent of economic activity, the summit was seen as one of the few events that could provide a tangible shift in policy efforts from domestic to global that could finally correct the momentum behind the world’s recession and financial troubles. However, the statement full of action points released after the gathering offered broad goals; but the steps to accomplish such high level objectives were lacking. With only a day to come to a very difficult agreement, expectations were already low. A completely different prop to the T-note’s strength has been the Fed’s pursuit of quantitative easing. After the Fed’s decision to keep rates unchanged at the last policy meeting, the market’s true interest was in their plans to increase purchases of longer dated Treasuries in an effort to lower interest rates.

Looking over the coming week and beyond there will be a few notable fundamental themes deciding the market’s interest in the safe haven Treasury. The most immediate and unpredictable dynamic is the impact earnings season will have on growth forecasts. First quarter numbers are coming down the wires; and recent optimism will have to be reconciled to the reality of weak demand and production synonymous with a general recession. Expectations are already set low; but a disappointment could defer the forecasts for the eventual rebound in growth. Furthermore, the market may intensify its focus on the accounting for the nation’s 19 largest banks. There have been suggestions that the Fed is holding back the release of the ‘stress tests’ done on these largest financial institutions until after earnings season (and that officials have told management at these corporations not to allow any premature leak). As such, market participants will fall back on speculation. Ongoing writeoffs (even after the change to accounting rules) and a unwavering decline in revenues could play on fears.

European Government Bonds

• Gilt Traders Show Tempered Confidence In G20 Outcome
• Bunds May Soon Find The Support Of The ECB

European Policy Authorities Bank On A Natural Recovery As Options Running Out

UK 10-Year Government Bond (Gilt)                          3.285      -23bps
Few economies stood to benefit from a strong and coordinated G20 effort more than the United Kingdom. The economy has been ravaged in the worldwide downturn (leading the IMF to predict Europe’s second largest economy to suffer the worst recession in the industrialized world through 2009) and the fires of financial crisis have grown so hot that the government has long fallen back on quantitative easing and nationalization. However, the vows the world’s leaders ultimately announced were released upon a skeptical market that immediately realized the lack of a catalyst to put such sweeping efforts into motion. Since this release, we have seen both Parliament and the Monetary Policy Committee hit theoretical barriers on their capabilities for turning local growth around. The BoE rate decision had no room for further cuts; but the group did announce its intention to hold up efforts to purchase 75 billion pounds worth of Gilts over three months. This will certainly keep the benchmark paper bid. What’s more, speculation will begin to ramp up for the advanced reading of first quarter GDP reading, Chancellor of the Exchequer budget statement and quarterly manufacturing report all due next week. Such a complete reading for activity could be either boon or burden.

German 10-Year Government Bond (Bund)               3.340       -1bps
The pull-back in the ten year bund from its record high a month ago has finally stalled. More or less following the general path of investor sentiment over this period, we have seen the fragility of this confidence wear away in the face of true fundamentals. Still considered one of the strongest, major economies in the world, the Euro Zone (and its largest members) has the most room to fall should conditions continue to decline. The growth outlook has been dealt few favors with rising unemployment, devastated output figures and sentiment tethered to record lows. As the release of first quarter activity numbers near (due in early May), the reality that this regional powerhouse is in the same situation many of its global counterparts are in (just behind the curve) could encourage diversification away from European sovereign debt whether investor sentiment is rising or not. What’s more, the decay in economic health further diminishes the European Central Bank’s position. The benchmark lending rate is still at 1.25 percent; but this leaves little room to maneuver. Should the need for lax policy outlast the central bank’s frugality, they may finally have to turn to the quantitative easing that the US and UK are already practicing. Expansion of the bank’s balance sheet would not only undermine the nation’s role as a source for yield; but it would also wear on the bund’s safe haven status.

Asian Government Bonds

• Japanese Officials Prepare Another Round Of Stimulus
• Will Chinese Demand Encourage A Rebound In Japanese Exports

Japanese Government Bonds Plunge As Bailout Efforts Balloon

Japanese 10-Year Government Bond (JGB)                    1.716        3bps
Over the past few weeks, Japanese government bonds have plunge precipitously. This move departs from that of its global counterparts; though the fundamentals warrant it. While it is true that market participants are still desperate for liquidity, not all government debt is created equal in its status as a safe haven. As the second largest economy in the world, JGBs are hardly questioned for their payment status; but with alternatives like US Treasuries, Bunds and Australian government paper, money managers can afford to be more discriminating with their Japanese investments. A critical look at Japanese economic activity (the worst recession in over a quarter century with central bankers forecasting a more aggressive recession going forward) and the nation’s financial health exposes an economy whose suffering will be leveraged by its dependency on exports and foreign investment. What’s more, the government’s aggressive efforts to correct the economic malaise have ballooned national debt. With yet another financial stimulus package in the pipeline (this one weighing in around $154 billion), the government has boosted spending nearly 3 percent of GDP and has to raise debt to fund such efforts.

Questions? Comments? You can send them to John at jkicklighter@cfdtrading.com.