Bond Expert: Wednesday Outlook

Prices of Treasury coupon securities sagged in overnight trading as the flight from risk-averse assets continued and the heavy calendar of Treasury issuance became reality.

The yield on the 2 year note has increased 5 basis points to 0.81 percent. The yield on the 3 year note has climbed 5 basis points to 1.10 percent. The yield on the 5 year note has climbed 4 basis points to 1.69 percent. The yield on the 10 year note has jumped 4 basis points to 2.48 percent and the yield on the Long Bond has climbed 4 basis points to 3.04 percent.

The Treasury will auction $30 billion of 3 year notes today.

At 815 AM New York time ADP will release its monthly report on employment growth. I read a piece yesterday (UBS I believe) which said they had revised their methodology. I do not think there data has correlated particularly well with the Labor Department data so I do not think there will be significant response to this information.

In Asia the Vice Chairman of China said that it would be an “arduous task” to keep growth steady. I wonder if the born-again central planners here will have such humility or if hubris will overwhelm that sentiment in Washington.

In New Zealand the trade deficit narrowed as the recession cut domestic demand.

In Japan Toyota (TM) is negotiating with its unions and seeking wage cuts from its workers.

In Europe PPI recorded its biggest drop since the collection of this data began in 1981. Declining energy prices led to a 1.9 percent plunge in PPI and reduced YOY inflation at the producer level to 3.3 percent in November from 6.3 percent in October.

Unemployment increased in Germany for the first time in three years and the number of persons out of work increased by 18K. The rate remained steady at 7.6 percent.

Morning Miscellany: I get quite a bit of correspondence from dealers and on much of it I have promised anonymity. I received one note this morning from a trader who thinks that the Federal Reserve has purchased nearly $10 billion in mortgages the last two days. In that time the spread to Treasuries has collapsed by 60 basis points to 127 basis points. The trader suggests that the Fed will move that spread to about 100 and then act to maintain it there.

The same trader made the humorous point that Reagan’s first budget director David Stockman, received a pink slip for saying that the Reagan budgets would leave the economy with budget deficits of $200 billion as far as the eye could see. The humor (very dry kind, which is best) noted that the President in waiting said essentially the same thing yesterday about trillion-dollar deficits.

Treasury Secretary Paulson will speak about the GSEs at 1200PM New York time. Kansas City Federal Reserve President Hoenig will speak on the US economic outlook at 100PM New York time.

I should have included this in my opening comments as it probably is the biggest story of the day: Alcoa (AA) will make 15 000 human beings redundant as it responds to slumping demand. The company will sell some assets and slash its capital spending budget.

Fails

Yesterday I posted the release from the Treasury Market Practices Group and its suggestions for a solution to the fail problem and a timeline for implementation of those suggested reforms.

I think that a very succinct summary is that if you are delivering securities versus payment, you will be charged 3 percent if you fail to make timely delivery.

I spoke with several traders today who suggest that the new rule would impair rather than improve market liquidity. It would virtually destroy relative value trading as a trader will not want to short an issue for fear of getting caught in this 3 percent trap.

One trader suggested that the Treasury could solve the problem with larger issue sizes. The current 10 year note will be over $50 billion dollars strong following the auction Thursday. He suggested that the Treasury should make reopening the standard practice for all benchmark issues.

I believe the last 2 year note issue was $38 billion. In this trader's view the Treasury should reopen that issue at the end of January and make the issue a $76 billion behemoth. It is unlikely that there would be many fails in an issue that size.

This idea would apply to all of the benchmark issue.

Additionally, the Treasury could become more aggressive in reopening off the run issues. Last year when the fail issue first surfaced, the Treasury responded by reopening four issues in the 7-year through 10-year part of the curve. I recall that on one afternoon they gave the dealers about one hour to set up for $20 billion of issuance.

That temporarily put the fear of God in traders and repo desks and alleviated the problem for a time.

IG 11 is opening 6 tighter at 188/191. For some perspective, the day that the FOMC announced the virtually zero percent funds target, the index was trading around 260.

Libor opening

Libor US$ Fixing 1/07 1/06 Change
OVERNIGHT 0.10750 0.12375 -0.01625
1 WEEK 0.28375 0.29750 -0.01375
2 WEEKS 0.32875 0.34375 -0.01500
1 MONTH 0.40625 0.42063 -0.01438
2 MONTH 1.07250 1.09125 -0.01875
3 MONTH 1.39750 1.41125 -0.01375
4 MONTH 1.50750 1.52625 -0.01875
5 MONTH 1.63750 1.65750 -0.02000
6 MONTH 1.75000 1.77000 -0.02000
9 MONTH 1.89250 1.92500 -0.03250
12 MONTH 1.99500 2.04625 -0.05125