Treasury Yields to Rise Further

by: Dan Carty

So what is a better environment for the treasury market: slowing inflation or weakening growth? Well, based on what is coming this week via the economic calendar we will get an answer to this most frequently asked question among traders. However, in order to find out how they will gauge these reports this week, we must look on what is going on in the present environment.

First and foremost, the current direction of treasury yields is higher. Things turned up from my own trading models a week ago Friday and every day this past week, yields went higher. This general lack of volatility (or one sided trade, if you will) could indicate that traders are switching their views from inflation to growth, as the stock market currently is exhibiting. With the stock markets move over the past quarter, traders are starting to seriously think what rising growth could do to the current inflation picture.

Is Growth Good or Bad for Inflation?
And this is a mindset central bankers across the globe have been telling the markets since inflation became a problem a few years ago. The question of whether the rise in growth would push inflation exponentially higher has been the debate among inner circles of the Fed, the UK’s BoE and the ECB: the thought that 2.5% CPI rates could turn into 4%, 5% or heaven forbid 10% down the road.

This is the proverbial “what if" scenario. Now is all of this realistic? In my opinion, no, but if a story is pounded into a traders' minds enough and then stock markets start to grow at a greater rate than historically (10%), fear creeps into the back of their minds about inflation and sellers emerge. In this case, treasuries are sold and yields move higher.

Confirming this fact could be the movement in the short rate 13 week bill. A few months ago, it looked to break lower as the Fed was taken out of the equation by the marketplace. Now that appears to be shifting towards the side of the rate hawks and at least stable rates (if not higher). Internal buying and selling pressure of this bill has again shifted back to the sell side with an uptick over the recent periods. With this tightening here, the rest of the curve is bound to move higher given the action in stocks.

So that leaves me wondering in regards to trade this week. As I mentioned Friday, I shifted my long position from the beginning of the year to the short side in the S&P. If stocks were to fall down this week (taking back some of the gains of the past few months), then treasuries may find support as money flows out of stocks and into bonds delaying any moves to higher levels this week. However, if stocks continue to move, treasuries will continue to move as well…higher in yield!

Here is a rundown of each sector followed.

Short End (13 week bill, Eurodollars)
As I mentioned last week and the week before, the short 13 week bill had put in a double bottom and was getting set to challenge the top of the range. Now that the bill is there, will the index breakout beyond the previous highs? That question perhaps sits with the stock traders who have been creating doubt on inflation within the very convinced lower inflation crowd of late with higher, increasingly fast, stock moves. During the last rate cutting cycle, it took four years before the turn occurred for yields. Since we are in year 3 of the current move, we could see progressively higher rates in the futures over the short curve and thus the lows or more stable policy in 2008. As a result, I would be looking for higher rates but nothing crazy.

Middle of Curve (5, 10s)
As I mentioned in my casino piece, the five year note is a good indication of which way growth is heading. At the moment, I would hazard to guess that the economy is now picking up steam as the five year climbs higher over the past few months. In a way the five year confirms, with the 10 year, that growth is rising. Current trends at the moment look to higher rates in the coming months. This is confirmed on the long end by the 10 year as well (and I continue to look for higher rates there as well). Overall the curve in the middle is positioned to head higher.

Long End (Bond)
What is most interesting about the long bond at the moment is the fact that it hit the bottom of the trading range near 4.50% and is targeting 5.25% now to the upside. There is one more fact though to add to this equation and that would be a trend line drawn from the peak in 1994, the peak in 2000 and the recent peak in 2005. A break of this major trend line could lead to a major breakout in yields – which is basically what I am arguing for. The chart of the bond though is the clearest which makes me wonder if the bond will be the leader of the curve and higher rates. Support for a higher move in yields come from the net index which is on the move higher (in favor of higher yields) and the buying pressure index which is bouncing off support. I would be bearish at this point on the bond.

Position: Short the March 10 year Note.