Bond Expert: Wednesday Outlook

Prices of Treasury coupon securities have posted sharp losses in overnight trading. The surge in equity markets around the globe continues as the price of oil touched a new low overnight. European stocks are higher by about 1.5 percent. The Nikkei gained 0.7 percent and the Hang Seng posted a 2.7 percent gain. The continued strength in equity markets reduces the attractiveness of Treasury debt as a safe haven investment. That shift in demand for risk averse assets is ill-timed as the Treasury is in the midst of a very heavy supply period.The Treasury will auction $31 billion 2 year notes today and $21 billion 5 year notes tomorrow. The $31 billion 2 year is the largest auction of that security ever.

The yield on the benchmark 2 year note has increased 5 basis points to 2.77 percent. The yield on the 5 year note has jumped 6 basis points to 3.52 percent. The yield on the 10 year note has climbed 4 basis points to 4.14 percent. Finally, the yield on the 30 year bond has moved higher by 4 basis points to 4.69 percent.

The 2 year /10 year spread is 137 basis points this morning.

In concert with the drop in oil, the dollar continues to strengthen versus the Euro and the yen. FX traders have taken heart from Paulson’s support for the dollar yesterday. Traders are also cheered by the remarks of Federal Reserve apparatchik Plosser who has called for higher rates sooner rather than later.

Some readers have questioned my disparaging remarks about the inflation hawks amongst the central bankers of the world.

I realize that there is an incipient inflation problem. I do not make light of it. However, wages are the single largest component of business cost. Inflation has not yet taken hold of wages and caused a wage price spiral such as we experienced in the late 1960s and the 1970s. Unemployment is rising and the economy has shed jobs nearly every month this year. That does not leave workers much wiggle room to bargain for excessive wage increases.

I would also point to the breakeven level on TIPS. I follow the breakeven on the 10 year TIP with great interest. As I write this that spread is trading at 239 basis points. That is about mid range of the broad 220 /260 range which has prevailed for several years. So there is danger signal there.

It seems to me that the larger problem confronting central banks is that the economy is in danger of a deeper and more protracted contraction.

I will be brief. The crisis which burst upon us last August brought with it a sea change in risk-taking appetite. Prior to the onset of this crisis, risk-taking was in vogue and risk-averse assets were shunned. Investors of every ilk marched down their personal credit curve to garner more yield. Little heed was paid to the type of assets which provided the returns.

Investors and banks have been burned to the tune of hundreds of billions of dollars. Some suggest that the total losses will be in the trillions. Against that background, banks have tightened lending standards and investors are seeking safe assets. This is a long-term process and it will take time for those wounds to heal. I think that we are in for a protracted period of slow growth and any attempt by central banks to restrict liquidity will damage confidence and make a bad situation worse.

I just do not see how the economy can return to status quo ante of July 2007 without a shift in risk taking appetites. I do not think behavior patterns shift that quickly and expect that change will be a long time coming.

Comments

[buyitcheap]

So if inflation isn't reflected on the long end of the curve, are you proposing that the yields should increase and therefore a short position in treasuries is a reasonable position? i.e. TBT? Or are you suggesting a coming flight to "quality" in which case be long the shorter maturities?

[Yiani]

What do you mean by the following statement?
"I would also point to the breakeven level on TIPS. I follow the breakeven on the 10 year TIP with great interest. As I write this that spread is trading at 239 basis points. That is about mid range of the broad 220 /260 range which has prevailed for several years. So there is danger signal there."

I hold TIPS. Should I sell?

[chick]

since rising interest rates also result in lower bond prices, which will have a better return over next year, money market or Tips, in a tax deferred account (529 plan)?