Bond Expert: Tuesday Outlook

Includes: FMCC, FNMA
by: John Jansen

Prices of Treasury coupon securities registered losses in overseas trading as the residue of the GSE bailout diminishes the need for risk free assets. The yield on the benchmark 2 year note has climbed 5 basis points to 2.35 percent. The yield on the 5 year note has also jumped 5 basis points to 3.02 percent. The 10 year note has experienced a yield increase of 3 basis points and yields 3.71 percent. The yield on the Long Bond has climbed 2 basis points to 4.28 percent.The 2 year/10year spread has narrowed 2 basis points to 136 basis points.

Economic news released overnight had a soft tint about it.

The German trade balance shrank more than expected as the surplus narrowed to 13.9 billion from 19.9 billion in the prior period. Exports fell 1.7 billion Euros as slowing global growth sliced demand for German manufactured goods.

Industrial Production in the UK dropped a greater than expected 0.4 in July and dropped 1.4 percent YOY.

UK home prices fell to the lowest level since 1978 in a survey from a group with the quaint name of Royal Society of Chartered Surveyors. Prices fell in every region surveyed. Sources blamed lack of mortgage liquidity as the culprit for the continued weakness in home prices.

European Union Commission member Joaquin Alumina issued a gloomy forecast for the European economy. He said that “prospects for second half 2008 and the beginning of 2009 are not very good”.

Global equities are posting mixed results. Asian and Australian markets dropped as growth concerns trumped the euphoria created by the GSE bailout. European equities are posting gains as the price of oil slides towards the century marker.

Futures trading indicates that US stocks will maintain the gains achieved yesterday and open modestly higher when trading begins in several hours.

The dollar remains a very strong currency and that is partly responsible for the decline in oil prices.

The dominant factor in US bond trading yesterday was the GSE bailout. It unexpectedly sparked a convexity event in the mortgage market as the shift in the current coupon created a huge demand for convexity from many mortgage market participants. As I wrote late yesterday, analysts believe that investors could need to buy the equivalent of $250 billion of 10 year swaps duration to meet their needs.

As long as the demand for spread product is that great, there will be an associated bid for Treasuries and the market should remain well bid.

Secretary Paulson with his bold strokes over the weekend has built a bridge to 2009 and left the future of the housing industry in the hands of the incoming administration and the next Congress. That is not a thought which should inspire confidence. Representative Barney Frank has been quoted as commenting that he opposes the reduction in the size of the GSE portfolios.

Senator Christopher Dodd from Connecticut is Chairman of the Senate Committee responsible for GSE oversight and legislation. He has taken umbrage at the rescue and has adopted what I will call as the Hillary Clinton position. The junior Senator from New York, in her ill fated and ill managed Presidential campaign, adopted the unique position that she had voted to authorize the Iraq war in 2002 but she never believed that President Bush would use the authority.

Senator Dodd has taken the same position regarding the plenipotentiary and Gulf of Tonkinesque powers granted to Secretary Paulsom for the solution of a GSE crisis. Dodd said that he never thought the power would be exercised.

The bailout and rescue makes sense as a short run solution to a problem which would have threatened the global financial system. It is incumbent on legislators to fundamentally alter the way that mortgage credit is parceled out here in the States. The role of FNMA (FNM) and Freddie Mac (FRE) should be dramatically reduced and constrained. They were financial sewers and accidents waiting to happen. To allow them to survive in anything like their previous form would be a policy travesty and an opportunity wasted.


MBS are opening about 6 ticks wider to swaps this morning. The rally yesterday was epic and so there is some normal profit taking this morning. One dealer noted that there were still small shorts capitulating. Others are looking for the convexity bid to keep the basis firm.

IG10 and other credit issues

The IG 10 is opening a basis point tighter at 138.

Credit Suisse analysts have a very negative view on credit spreads and hold that any near term tightening is an opportunity to reduce exposure.

They note that there has been a substantial Treasury market rally and that will lead to heavy issuance.

According to the analysts the suspension of of dividend payments on preferred shares of FNMA and Freddie Mac will make it more difficult for banks to fund themselves.

In a few days some of the large investment banks will begin releasing earnings. It won't be pretty. The confessional booth should soon open also and firms with less than festive Q3 prospects will probably start issuing earnings warnings.

Credit Suisse analysts believe that credit issues for banks will shift to prime loans and credit cards,exacerbating their woes.

And with quarter end nigh, balance sheet issues should add to pressures on spreads.