Bond Expert: Wednesday Outlook

Prices of Treasury coupon securities have surged in overnight trading, partially erasing recent losses and reflecting a shift in sentiment to the debilitated condition of the global economy and away from the euphoria spawned by actions of governments to stave off imminent financial collapse. If focus does shift back to the economy, bonds should benefit and equity market gains should be restrained as a sober assessment of the global economy, in my opinion, will render a judgment that we are in for a protracted period of weakness.

I say that because the current and ongoing credit crisis has fundamentally altered appetite for risk. The economy has just passed through a decade-long period in which nearly any risk was good risk. In this period, there was a defenestration of common sense as lenders accepted increasingly smaller returns for their acquisitions of very murky assets. As poorly placed as those purchases were, there is no question that these activities boosted the economy earlier in the decade via the housing boom and its attendant excesses.

Obviously that episode is over and will live forever as fodder for many a dissertation and seminar topic. The result, though, is that with risk at every level reduced and balance sheets severely constrained, there will be a rationing of funds for productive and worthy ventures. Most revolutions end in excess and the revolutionary transformation of the economic landscape through which we are passing will be no different. Excessive restraint and caution will be the order of the day and that is not a salutary outcome for entrepreneurial initiative and innovation.

Additionally, the pendulum of history has begun to swing against the mostly free market policies of the last three decades. Whoever is elected President in less than three weeks will usher in a new era of business regulation. If John McCain should prove to be this era’s Harry Truman and win in an upset, he will bring change but in a tempered fashion.

In the likely case of a Democratic sweep of the Presidency and the Congress, I believe that the frustrations of the last eight years will be vented with Jacobin zeal and will produce legislation which will constrain economic activity. I am not making a normative statement about that but just reflecting what I believe will be the result of the exercise of power by a majority which for many years had its nose pressed against the legislative window.

So, in my opinion, the union of a reduced appetite for risk at nearly every level with an increased appetite for government involvement and regulation will lead to lower levels of economic activity and a protracted period of economic weakness and slower growth when the recovery finally emerges.

The yield on the 2 year note has slipped 8 basis points in overnight trading to 1.73 percent. The yield on the benchmark 5 year note has dropped 10 basis points to 2.92 percent. The yield on the benchmark 10 year note dropped 10 basis points, also, to 3.98 percent. The yield on the Long Bond has slid 5 basis points to 4.23 percent.

The 2 year/10 year spread is flatter by 2 basis points at 225 basis points.

The US bond market will keep its eye on the economy today as participants will weigh the Retail Sales data and the PPI report. Expectations are that each of these reports should be friendly for those who pass time clipping (bond) coupons.

The IG 11 is opening 7 wider as it is quoted 181/184. One dealer makes the interesting point that with government backing in place financial names should enter a period of stability.

However, the same dealer posits that non financials should decouple and in the recessionary environment should significantly underperform financial names.

Libor is expected to open 5 basis points to 8 basis points lower across the curve. ( Not a shameless plug.) One dealer reports some buying of one week and one month ABCP in Europe. The level of activity is light and the purchases have been confined to AAA names.

*THREE-MONTH DOLLAR LIBOR 4.55% VERSUS 4.64%, BBA SAYS
    *ONE-WEEK DOLLAR LIBOR 3.83% VERSUS 4.08%, BBA SAYS
    *OVERNIGHT DOLLAR LIBOR 2.14% VERSUS 2.18%, BBA SAYS

Swap spreads are opening a bit tighter. Two year sector spreads are tighter by 2 1/4 basis points, five year sector spreads are tighter by 1 3/4 basis points and 10 year sector spreads are tighter by 3 basis points.

Comments

[whidbey:]

Interesting commentary. The concern for the economy will be short lived as the next phase of credit failures in commercial real estate and credit cards start to wash up on the beaches. Bonds may be more attractive as a safe haven investment, but only if the yields rise accordingly. The flutter over night was hardly a reformation. What can we think of the amount of capital that the Treasury must make available? In anything but a recessionary economy it would have an inflationary effect. Now? I suspect slow stagflation as we wallow in a liquidity trap with new cooks in Congress making new things. Pain! If bonds, buy the instrument and stay away from bond funds.

2008 Oct 15 10:17 AM