Wednesday's Bond Outlook: Expect a Rocky Ride

Prices of Treasury coupon securities continued to slump in overnight trading as inflation fears resonate ahead of the CPI report later this morning. Oil stoked those fears as it traded at nearly $127. A chorus of Federal Reserve official spoke yesterday and many of those who spoke expressed concerns and cautions about the level of inflation and the challenges which lie ahead in containing it. Additionally, Treasury securities have lost their safe have status. Bloomberg reports that the TED spread traded near a 12 week low.

Treasury debt has also suffered technical damage in overnight trading in that benchmark issues have breached key support levels.The yield on the benchmark 2 year note has jumped 4 basis points and rests (uncomfortably) at 2.52 percent as the 2.50 level did not hold. The yield on the 5 year note has increased by 3 basis points to 3.20percent. The yield on the benchmark 10 year note has surged to a new high and at the moment yields 3.94 percent. That is a tad cheaper than the average level attained in the refunding auction last Wednesday and augurs ill for that issue. The Long Bond trades at 4.66 percent and is 2 basis points higher than its close. It is also well underwater relative to its auction level of 4.599 percent last Thursday.

The 2 year /10 year spread continues to collapse, reinforcing the notion that the steepening last week resulted from the refunding supply. The spread has tightened to 142 basis points in overnight trading. During the underwriting process last week that spread reached 158 basis points. That is an example of what I have always referred to as “shooting the taxpayer in the big toe”.

Equity markets in Asia are mostly higher. Share prices surged more than 3 percent in mainland China as the tragic earthquake sparked fears of disruptions in commodity supplies. Japanese shares climbed more than one percent on dividend increases. Hong Kong stocks dropped marginally. European stocks are, on balance, slightly higher. Futures markets are positing a slightly lower open when US trading begins.

US markets await the CPI report at 830AM New York time. Prognosticators expect tame results with the headline expected to print 0.3 percent and the ex food and energy metric at 0.2 percent.

Benchmark Treasury securities are failing to attempt even a feeble bounce from some of the cheapest levels in months. If the CPI data are less than festive this morning, then the market could turn quite ugly and the 10 year note should breach the 4.00 percent level. Even if the number is somewhat friendly I believe that the horrible price action has damaged the market and trapped longs will be sellers at slightly higher prices.

Strap yourself in, because this might be a rocky ride.

Have a good day.

Comments

[EE]

Why would anyone hold bonds longer than this year when M3 is growing at 19% and over 12% for years? Official inflation at 4% is really 2 or 3 times that and primed to go hyper with the $ ready to lose another 40% in 3 years or so. The sub prime problem is about half over and the derivative mess is in the 2nd inning and a much bigger threat not yet appreciated by most. The country is in deep shit and folks are walking out the door looking up and with out hip boots on. Buy hard stuff that industry and people need in place of paper promises. If you have gold & silver, take delivery and get more silver, junior mining and energy stocks. Read Ted Butler investmentrarities.com & Jason Hommel's silverstockreport.com ( feb 16/08 issue )

[bearfund]

EE, consider PST and TBT as well. It's almost impossible for me to imagine a scenario in which bond prices rise over the long term. Inflation? Eats away at yields, yields go up. Rate hikes? Short-term yields rise to meet them and long-term yields rise as well. Dollar weak? Who'd want to hold it? Dollar strengthens? Who'd want to buy low-yielding bonds with money that's even more likely to decrease in value? Supply is spiraling ever higher as the government fails to control its spending, and tax revenues will surely grow more slowly or even decline as the effects of the recession begin to be felt. Demand from foreign central banks is weak, with several explicitly looking for alternatives. There is nothing at all to like about Treasuries at any maturity. But I believe all the big money to be made right now is short the long-dated side of the curve, in which America's real prospects play a more meaningful role than knee-jerk "oh shit, panic in the financial sector, buy T-bills!" buying. When the 10-year note yields 10%, I'll reevaluate that - and my positions. Until then, long PST TBT.

[whidbey]

The Fed can not accept a steep rise in bonds, especially the long bond, if it hopes to restructure the financial, housing and consumer credit markets. The Fed will be against the wall: needing higher rates to fight inflation and lower or constant rates to revive the economy. God knows what Congress will add to the problem, it could force the home bail-out and tank the dollar even further. It is to quote the man "Likely to get rocky."