Bond Expert: Wednesday Outlook

Includes: IEF, IEI, SHY, TLH, TLT
by: John Jansen

Prices of Treasury coupon securities have posted modest losses in overseas trading. I do not see a strong impetus in the news for the small declines in Treasury prices. Stocks around the globe are trading well with robust gains in Europe and healthy advances in Asia. So I will opine that those gains and futures market indications of solid gains when trading begins in the US are sapping strength from bonds.

Bond traders also confront the uncertainty of the FOMC meeting and the policy statement from that group at about 2:15PM New York time. I believe that the FOMC will acknowledge the continued improvement in the economy but will genuflect to the depth of the recession and its associated headwinds and will reaffirm the need to hold the funds rate at an unusually low level “for an extended period”.

At the meeting with senior Treasury officials which I attended on Monday, I have noted previously that those officials expressed real concern about the downside risks to the economy (as did blogger Michael Panzer of Financial Armageddon) and since I think that the relationship between the Treasury and the Federal Reserve has morphed into something somewhat incestuous I suspect that the Federal Reserve will not jump off the reservation and take the first baby steps to exiting its easy money policy. (I also apologize for what could be the longest sentence in the storied history of Across the Curve dot com.)

Separately, the Treasury will release details of the November refunding this day. The auctions will be held next week. The conventional wisdom anticipates that the Treasury will offer about $40 billion 3 year notes, $25 billion 10 year notes and $15 billion Long Bonds. The Treasury will also address funding issues.

The rate at which the Treasury issues bonds is a little frightening and given the prospect of trillion dollar shortfalls as far as the eye can see the Treasury will at some point find it necessary to introduce some wrinkles into the funding mix. As programs such as the TARP unwind that will replenish the Treasury’s coffers somewhat but that amount seems trivial in relationship to the amount that the Treasury is issuing.

Here are some numbers to put the borrowing appetite of the Federal government into some perspective. The Treasury lifted the three year note from its dusty pedestal in the bond museum and reintroduced it last November. At that time the issue size was $25 billion. The one that they will announce in an hour or so will be about $40 billion. That is an increase of 60 percent. I doubt that they will raise it by another 60 percent in the upcoming year but since they still need bucks from whence will that come. The more pressing issue is not today but is in the not too distant future.

This month when they offer the 3 year note they are raising all new cash as there is no maturing 3 year note. But 2 years hence when the $25 billion which they offered last November matures, the issuance will raise significantly less money. Given that the forecast for the deficit is for a stream of thirteen digit shortfalls, the Treasury in the future will need to be very innovative or scarily large when it comes to market.

I also think that the belly of the Treasury curve is approaching the level at which the market is saturated. I noted that the 3 year each month is now about $40 billion. Similarly, the 5 year note each month is about $40 billion. And the 7 year note which Treasury introduced onto the cycle in February is now 31 billion each month. Quick calculation will demonstrate that via those issues the Treasury raises a little more than $ 1.32 trillion per annum.

The amazing thing here is that the 3 year note and the 7 year note were only added to the cycle recently. As I noted the 3 year joined the fray last November and the 7 year climbed onto the menu in February. As an aside the 7 year in February totaled $22 billion and in less than a year has seen its monthly size jump by 40 percent. If you take the $40 billion 3 year notes and the about $30 billion of 7 year notes each month that is $840 billion of annualized issuance which did not happen a year ago.

I am running on here but one last point. Selling this paper has been to some extent easy as foreigners have been buyers and the Federal Reserve has been a buyer (a genuflection to the ever present crowd on the grassy knoll) and the Federal Reserve has been engaged in an easy money policy.

There will come a time when the Federal Reserve raises rates and I wonder what the auction process will look like when the market for interest rates turns into a bear market. When investors and dealers look at the world and determine that it will be better for them to delay bond purchases because the Federal Reserve is busy raising rates the outcome will be rather ugly.

I will dispense with my usual recitation of yields and curve relationships this morning. Rates have risen pretty much two basis points across the curve.