By Rom Badilla, CFA
Interest rates have rallied tremendously in recent months as concerns of an economic slowdown and the potential for a double dip weigh on the minds of both Wall Street and Main Street. Since early April, which marks the recent high in rates, the long-end of the curve has rallied significantly. The yield on the 10-Year U.S. Treasury has declined more than 100 basis points to 2.97 percent during that time frame.
That type of change usually takes many months, if not years, to accomplish. The average implied volatility of both interest rate swaptions and options on Treasuries over the last 10 years is around 100-120 basis points on an annualized basis. Hence, the move to where we are now is quite significant.
Admittedly, part of the decline is attributed to a flight to quality due to fears of contagion from Greece and the European debt crisis. However, the last leg of the drop in yields was due to signs of a slowing economy and declining price pressures. If it were a continuation of the flight-to-quality trade, we would have seen the dollar appreciate as was the case earlier when the Euro approached parity as sovereign risk escalated. Lately with the recent string of weak domestic economic data, the dollar has declined 1.7 percent from June 21 while the 10-Year rallied 26 basis points and pushed below 3 percent.
If there’s any argument that there is a bond bubble, keep in mind that there needs to be an imbalance, i.e. a shift in outlook toward lower rates. Basically, the majority of the world needs to be on one side of the boat, where tipping over is a possibility and the imbalance is ultimately rectified. Right now, we are far from that.
According to Bloomberg’s economic and interest rate survey, market participants still expect higher rates to materialize with the Federal Reserve raising rates in early 2011. In additions, forecasters expect the 10-Year to increase 40 basis points to 3.37 percent by the end of the Third Quarter.
Rate hawks and bond vigilantes are still advocating for higher rates as the U.S. grapples with both perceived higher inflationary expectations fueled by future economic growth and higher fiscal deficits. To be honest, after packing on the calories by downing countless hotdogs and burgers this past weekend, I would not mind drinking some of that kool-aid to wash it all down. Unfortunately, it won’t make a difference as far as changing the realities of the economic outlook.
As discussed many times here on Bondsquawk (is the horse dead yet? Apparently not!), we think that economic growth into the second half of the year will be lackluster for many reasons. Amid waning government stimulus, excess and slack in resources should point to slower economic growth and lower price pressures, which in turn should lead to declining inflation expectations and bond yields.
Commercial real estate is still showing problems as vacancy rates continue to rise. While the lone bright spot is multifamily property types that is benefiting from the housing collapse as people prefer to rent than own, the National Association of Realtors reported in its May Commercial Real Estate Outlook that vacancy rates for office, retail, and industrial space should increase and not level off until late this year or early 2011. For these types, rental rates should decline this year and 2011 as the sector experiences “negative net absorption” and as more commercial space frees up. Declines in rent should place further pressure on overall prices as well as negatively affect lending since small to mid-sized banks are filled with commercial real estate loans. As banks wrestle with bad loans and assuming that they survive, loans for businesses will continue to be difficult to come by.
Housing appears to be headed for a double dip as recent home sales failed to continue once the federal tax incentive expired at the end of April. Existing Home Sales for May came in at 5.66 million (annualized), a decline 2.2 percent from the revised prior period figure of 5.79 million. New Home Sales for May reached a record, surpassing the all-time low set in September 1981, by tumbling 33 percent from the prior month to an annualized figure of 300,000. With slowing sales, inventory is piling up.
Existing-home inventory on the market for May stands at 3.89 million units for sale which represents about an 8.3 month supply at current sales pace. In addition, inventory may increase as banks, who are currently encumbered with empty homes waiting to be processed in foreclosure, catch up and begin to unload more supply in the coming months. This “shadow” inventory, which amounts to about an original principal balance of $480 billion or 30 percent of the entire non-agency market, is not included in current inventory numbers but could take another three years to clear at the current resolution rate according to Standard & Poor’s in a June 9, 2010 report. S&P concluded that given the backlog, “home prices could fall again if demand doesn’t rise in step with the potential influx of supply.” Unfortunately and despite the accommodative environment for mortgage rates, demand should not be picking up anytime soon.
Unemployment is still a problem. Initial Jobless Claims ended on a down note as the weekly measure ticked up again to 472k people filing for first time unemployment benefits. The 4-week moving average, which is used to smooth out the volatile weekly reading and now stands at 466.5k, has been trending sideways between 450k and 500k since November 2009. There has been no improvement and signs point to further job destruction. In order for job creation, Initial Jobless Claims needs to drop below 400k and stay there for a period of time.
Payrolls, in particular in the private sector, have been pathetic given the amount of federal stimulus that was put in place. Not only the government failed to hand the baton off to the private sector, the government just outright dropped it with its mal-investment. Since January 2008 to December 2009, the U.S. economy has lost close to 8.5 million jobs in the private sector. Since then, the headcount has increased by only 600k with a gain of 33k and 83k for May and June, respectively. This brings the 2010 average to about 100 per month (I am being generous here since I had to round up) which at this rate will take us about a six to seven years to get to pre-recession levels of employment. Wake me up in 2016.
Given that the majority of the world is still expecting higher rates as evident by the Bloomberg survey, bonds are not in bubble territory. Even though bonds have rallied significantly, the fact remains that there is a lot more upside for bonds. Slack in asset prices, specifically residential and commercial real estate, coupled with sticky high unemployment, will ultimately lead to both an economic slowdown and lower inflation expectations, which will in turn, lead to further gains for bonds. If you thought that rates were already low, wait awhile and see them go even lower.