Bond Expert: Friday Outlook

Prices of Treasury coupon securities have rebounded from the calamitous levels attained following the release of the results of the disastrous 30 year bond auction.

In overnight trading, the yield on the 2 year note has slipped 2 basis points to 1.22 percent. The yield on the 3 year note edged lower by 2 basis points to 1.60 percent. The yield on the 5 year note dropped 2 basis points to 2.40 percent. The yield on the benchmark 10 year note fell 5 basis points to 3.81 percent and the yield on the tainted Long Bond edged 4 basis points lower to 4.32 percent. Equity markets around the globe responded to the huge and senseless US rally and posted solid gains, albeit smaller than those posted in the US. Major Pacific region markets bounced between 1.3 percent (Australia) while Hong Kong and Japan were up 2.4 percent and 2.7 percent, respectively.

Stock markets in Europe, on balance, have registered gains of about 3.0 percent.

Economic data released overnight shows that the economy of the states in the EU declined 0.2 percent in Q3 after declining the same amount in Q2.

Inflation in the Eurozone eased in October as it declined to 3.2 percent YOY from 3.6 percent YOY in September.

In the US, participants brace for the monthly retail sales report. The consensus is for the headline piece to drop about 2 percent. I will play amateur economist again and suggest that the decline will be greater than 3 percent. Consumer confidence has been shattered and the labor market is melting. Most of that data which has printed the last several weeks has been weaker than expected and I see no reason why that should not happen in this instance, too.

I am always flummoxed by the actions of the equity markets. (In the interest of full disclosure I have a moderate sized short in stocks and a moderate long position in the 10 year Treasury. So the price action dented my P and L.) There are credible forecasts that current quarter GDP will fall between 3 percent and 4 percent. I was never very good in science but I recall that a long-haired fellow in the 17th century suggested that a body in motion would tend to stay in motion. Against that scientific background, Q1 2009 should remain solidly negative. I guess one could make the case that some growth returns in Q2 2009 but that is grand conjecture at this point.

I think that there are numerous forces arrayed against the economy and that any recovery when it shows up will be piddling.

There has been a fundamental and permanent shift in appetite for risk. Every revolution ends in excess and so will the revolution in risk management. For many years there was a cavalier attitude which approved of imprudent risk taking. It was a game in which the rewards were not commensurate with the attendant risks. It was dumb and ultimately costly and system threatening.

I think that the shift to more prudent risk taking is necessary and proper but will be painful in the short run as firms overreact and reject many schemes as unwisely risky which are not. That strict construct will limit and constrain business activity unduly in the months ahead.

I also think that the new Administration will stifle business activity. (I voted for the man and the statement is not meant to be normative.) I think that the Adminstration and the new Congress will get their jollies by shackling innovation and risk taking in business. There will be no money to spend on beloved projects as the previous Administration is busy emptying the till as we speak.

I think the Democrats will take a pound of flesh from the business community in general and the financial community in particular. Against that background, it will be a difficult environment for business and that, too, will lead to a reduction in business activity.

The economy is in a deep hole and recovery will not come quickly. I think that the recovery will come but it will be a multi year process rather than a multi month process.

Consequently, the idea that levels attained yesterday in the equity market represents some value confuses me. Maybe if you are covering a short, but certainly not for the long haul. I think there will be opportunities to buy them cheaper later.

In the meantime I am eating at home this weekend!

Libor

What follows is the thoughts of a trader on the rise in Libor the last two days:

Libor set higher for the first time in 24 days.  The market took this as an
affront to spreads and proceeded to buy Libor/OIS pretty heavily. Why?  well,
yet again this marks a potential turning point in the credit cycle as Libor has
tended to trend in a meaningful manner and more specifically, over the past few
weeks one bank has done a tremendous job in getting Libor lower.  Does this
mark the end?  If this is the case, then we could be in for a wild ride over
the next few weeks.  Two days do not make a trend, but I would treat any
surprise moves higher in Libor as a warning and would not fight what could
potentially be another substantial widening. Volatility will surely be higher.

Libor US$ Fixing
11/14 11/13 Change
OVERNIGHT .41250 .40000 .01250
1 WEEK .91250 .87500 .03750
2 WEEKS 1.11125 1.06250 .04875
1 MONTH 1.47750 1.42250 .05500
2 MONTH 2.11625 2.04125 .07500
3 MONTH 2.23625 2.14875 .08750
4 MONTH 2.39250 2.30750 .08500
5 MONTH 2.54250 2.44000 .10250
6 MONTH 2.71375 2.59500 .11875
9 MONTH 2.80500 2.67000 .13500
12 MONTH 2.90500 2.75125 .15375