Bond Market Recap: Rallying Across the Curve

by: Bondsquawk, CFA

By Rom Badilla

U.S. Treasuries rallied today fueled by disappointing economic data and strong demand at today’s $40 billion 2-Year auction.

The National Association for Realtors released home sales activity for May which was significantly off the mark of economists’ surveys. Existing Home Sales came in at 5.66 million (annualized), a decline 2.2 percent from the revised prior period figure of 5.79 million. Economists were expecting an increase of 6.0 percent or a sales volume of 6.12 million homes. According to the NAR, sales appear to be inflated since 46 percent of sales were first-time buyers who were most likely motivated by recently expired federal tax incentive. While the tax credit helped, it certainly did not help enough to meet market expectations.

Existing-home inventory on the market for May dropped 3.4 percent to 3.89 million units for sale. This figure represents an 8.3-month supply at the current sales pace, a tick lower than the 8.4-month supply in April. Despite the decline, inventory may increase as banks, who are currently encumbered with empty homes waiting to be processed in foreclosure, catch up and begin to unload more supply in the coming months. This shadow inventory is not included in today’s release but could take another three years to clear at the current resolution rate according to a June 9, 2010 report by Standard & Poor’s. Obviously, increased supply supplemented by waning demand as evident by today’s data release, could place further pressures in the already-depressed housing market.

The U.S. Treasury department saw a spectacular auction of its 2-Year notes today that were sold at the lowest yield till date. The Treasury sold $40 billion worth of 2-Year notes today, which is two billion less than the previous auction. The yield for this issue was 0.74 percent, lower by 3 basis points than from the prior sale. The bid-cover ratio was 3.45, which was higher than the ratio of 2.88 of the last auction.

In a flight-to-quality bid, U.S. Treasuries rallied across the curve, led by the long-end. The yield on 10-Year Treasuries declined 9 basis points from the prior close to 3.16 percent. The 10-Year now stands within spitting distance of the recent lows and technical barrier of 3.10 percent (3.06 percent is the low on an intraday basis). The Long Bond finished at 4.09 percent, a drop of 7 basis points while the yield on the 5-Year was able to match the outperformance by closing out at 1.96 percent. After all that is said and done, the yield on the 2-Year came in at 0.68 percent, a decline of 3 basis points from yesterday.

10-Year U.S. Treasury Yield - Intraday Chart

Inflation expectations as evident by the yield differential between 10-Year Treasuries (aka nominals) and 10-Year Treasury Inflation Protected Securities (aka TIPS), resumed its downward march by declining today. The yield differential also commonly referred to as the “breakeven” rate decreased 5 basis points to 1.99 percent. Inflation expectations have come down significantly in recent weeks as breakevens have fallen 46 basis points from a high of 2.45 percent set in early May. The decline in breakevens coincides with equity weakness, signs of a slowdown in growth, and subdued inflation expectations.

The LIBOR-OIS USD spread finished slightly higher at 32.9 basis points from 32.7 set on Monday. The spread on the European counterpart jumped almost 2 basis points to 29. Despite the advance, the spread is below the level of 31.1 basis points set on Friday.

The flight-to-quality trade affected markets across the Atlantic as well as bonds from the developed economies rallied. German 5-Year bunds tightened 7 basis points to a yield of 1.59 percent. France’s 5-Year declined 3 basis points to a yield of 2.03 percent while the yield on 5-Year U.K. Gilts dropped 7 basis points to 2.16 percent.

As concerns over either a default or restructuring increase, Greek bond yields continue to march higher. The yield on 2-Year Greek debt increased 37 basis points to 9.21 percent while the 5-Year reached the double digit mark again by jumping 33 basis points to 10.14 percent. The yield on the 10-Year finished the day at 9.77 percent, a spike of 29 basis points.

Greece Yield Curve - Daily Change

Spain 5-Year bond yields increased 12 basis points to 3.70 percent. With Spain 5-Year CDS widening 14 basis points to a spreads at 250 basis points, the Cumulative Probability of Default now stands at 19.8 percent according to CMA data. The spread on CDS is the cost associated with owning protection against a default.

Around the rest of the periphery, Portugal 5-Year bond yields widened 12 basis points to 4.57 percent while Italy’s increased 5 basis points to 2.84 percent. Ireland was the long bright spot among the PIIGS as yields declined 4 basis points to 4.55 percent.

The U.S. credit markets were flat to wider on the day. The BofA Merrill Lynch High Yield Master Index ended an impressive six day rally by increasing 7 basis points to a spread of 675. The spread on both the U.S. Corporate Index and Bank Index got dressed up for nothing by closing where it started. The Corporate index which contains over four thousand investment grade bonds closed at 205 basis points over comparable maturity Treasuries. The U.S. Bank Index ended at a spread of 271 basis points.

As BP shares kiss the lows on the NYSE, spreads on the much-maligned oil company, spiked in CDS trading. BP 5-Year CDS increased 49 basis points to a spread of 526.

5-Year BP Credit Default Swap Spread - Historical Chart

Stocks couldn’t hold key technical support levels and declined. The S&P 500 lost 1.6 percent to 1095.31 while the Nasdaq dropped 1.2 percent to 27.29. The CBOE VIX advanced 8.4 percent to 27.05.

The Dollar Index rallied to 86.091, an advance of 0.2 percent. The Euro declined 0.4 percent to 1.2268 while the British Pound gained 0.3 percent to 1.4806.

Gold spot prices increased 0.5 percent to 1239.95.

The Federal Reserve will announce its decision on monetary policy as they conclude their FOMC meeting tomorrow afternoon at 2:15pm EST. The Fed is expected to maintain its Federal Funds target rate at 0.25 percent with similar language as before. In addition, the Mortgage Bankers Association will release applications activity for the week ending June 18. Also, New Home Sales figures is on for tomorrow as surveys suggest an annualized figure of 410,000 which is an increase of 18.7 percent. Thursday, Durables Goods for May will be released along with Weekly Employment Claims numbers with first quarter GDP figures set for Friday.

Maulik Mody contributed to this report