Tuesday, April 29, 2008

Treasury Tuesdays

The bottom line story of the last few weeks in the credit market is traders are moving into riskier areas of the bond market.

The major U.S. indexes have been rallying since hitting a trough in mid-March. The difference between corporate bond yields and ultra-safe Treasurys has narrowed, as has the spread between mortgage agency bonds and Treasurys. And the cost of buying a type of insurance against corporate defaults has plunged.

While the previous points are good news, they look an awful lot like bottom fishing by money managers to me. They are less indicators of intra-credit market sentiment and more indicators of speculative sentiment. As a result, I still think the LIBOR issues are troubling as the represent what banks are thinking -- especially about each other. And increasing LIBOR rates indicates banks are still concerned about other banks ability to repay loans.

Same point, different article:

Investors are turning to riskier investments that had been all but abandoned earlier this year, such as corporate bonds, where last week a record $40.1 billion in new debt came to market, including issues from embattled companies such as Citigroup Inc. and Merrill Lynch & Co. Meantime, the premium that investors are demanding on corporate debt -- even low-quality speculative grade, or "junk," bonds -- is coming down as fears subside.

"We established that the Fed was going to backstop the markets, keep things stable and slowly but surely nurse the markets back to health," says Daniel Shackelford, a portfolio manager at T. Rowe Price Group Inc. As a result, "risk-taking has come back in the market."

Another article made the same point:

While they are diving into riskier corporate debt, investors have been pulling away from safer Treasury bonds, especially among short-term securities most sensitive to Federal Reserve policy.

Many now believe that when the Federal Open Market Committee meets Tuesday it will lower the benchmark federal-funds rate by a quarter of a percentage point to 2% but will signal a pause in additional moves until the economic outlook becomes more clear.

The recent selloff in the market for Treasury bonds was fast and furious. Yields on U.S. Treasury two-year notes rose to 2.42% Friday from 2.17% the week before and substantially above the 1.33% low hit on the day after the Bear Stearns deal was announced. Yields rise as bonds' prices fall.

Mortgage-backed bonds, one of the hardest-hit corners of the market, also have improved, especially those backed by government agencies Fannie Mae and Freddie Mac. The spread on these bonds has narrowed by almost a full percentage point from March levels.

In the market where investors buy and sell insurance against corporate defaults, fears of a financial institution collapse also are abating. Insurance against default on $10 million of Merrill Lynch debt for five years now costs $167,000 annually, down from a high of $335,000 in mid-March, though it is still much higher than it was last June, when it was $25,000, according to pricing service Markit.

In the short term treasury market, notice the upward trend of last 6 months has been broken. That means traders are more comfortable with what is happening in the credit markets overall.

The short end of the Treasury curve was not the only part of the curve to see some selling. The 7-10 year also experienced some selling:

The 7-10 year area of the market has clearly seen some selling as well, as it has also broken an uptrend.

And the 20+ year is in an obvious trading range.

But we know that all is still not well in the credit markets, as LIBOR is spiking again:

An interest-rate based on what banks charge each other for loans has risen in the last week, sidestepping a general improvement in credit sentiment and acting as a reminder of the still-severe hurdles facing U.S. banks.

The London inter-bank offered rate, or Libor, has risen 23 basis points since April 1 to 2.91%, according to three-month U.S. dollar Libor rates quoted by FactSet Research. It's risen 33 basis points since mid-March, when several other market indicators instead started to show signs of improvement. One basis point is 1/100th of a percentage point.

"The stress in the money markets is still acute," said BNP Paribas economist Gizem Kara and colleagues in a note Thursday.

A higher Libor rate means banks are charging more for short-term loans to each other, suggesting they are more nervous about the borrowers' ability to pay back. It may also indicate banks, struggling with billions in bad loans, are hoarding capital and less likely to loan to each.

There were two auctions last week. Last Wednesday's auction went well:

Yields on two-year Treasury notes held near an almost two-month high after the U.S. sold a record $30 billion of the securities, indicating investors are more willing to buy debt even as expectations fade for interest-rate cuts.

The notes were sold at a yield of 2.225 percent, below the 2.2336 percent average estimate of nine bond-trading firms surveyed by Bloomberg News. The group of investors that includes foreign central banks bought a bigger share than their average over the past six auctions.

Indirect bidders, the category that includes foreign central banks, bought 33.6 percent of today's sale, the most in seven months. At the past six auctions, the group bought 23 percent on average.

That makes the horrible result of Thursday's 5 year auction that much more important:

``It was a horrible, horrible auction,'' said David Ader, head of U.S. government bond strategy in Greenwich, Connecticut, at RBS Greenwich Capital, one of the 20 securities firms required to bid at Treasury sales. ``An auction result like this is going to push people to say, `I'm going to step aside.'''

At today's sale, the biggest since February 2003, the bid- to-cover ratio, which gauges demand by comparing total bids with the amount of securities offered, was $1.65 for every $1 sold. That was the lowest since February 2003, and down from $1.98 in March.

Indirect bidders, a group of investors that includes foreign central banks, bought 29 percent of the securities, down from 34 percent in March.

Traders pushed two-year note yields to the highest level since Jan. 18 on speculation the central bank won't lower borrowing costs further after this month. The losses pushed the securities' yield above the Fed's benchmark rate by 14 basis points, the most since June 2006.

Remember -- the US government is bleeding debt right now (and will be for the foreseeable future). Consider the following:

The Treasury's deficit for the month of February totaled $175.6 billion, making for a fiscal year-to-date deficit of $263.3 billion -- up 62 percent from this time last year. Outlays are on the rise, up 10.2 percent year-to-date and reflecting rising spending on defense and higher interest payments, which are a result of the rising debt. Receipts are up this fiscal year, but only by 1.3 percent. Individual income taxes are barely higher and corporate taxes are 15 percent lower. Rising spending and falling receipts, and the risk that receipts will fall further as the economy weakens, are making the budget deficit a bigger and bigger issue for the economy and for the value of the dollar.

One of the main reasons for the decline in foreign interest is the slumping dollar:

The Japanese, who own $586.6 billion, or 12 percent of U.S. government debt, had their worst quarter in Treasuries this decade, losing 7 percent in the first three months of the year as the dollar fell to the lowest since 1995 versus the yen, Merrill Lynch & Co. indexes show. Dai-ichi Mutual Life Insurance Co., Meiji Yasuda Life Insurance Co. and Sumitomo Life Insurance Co., three of the nation's four-biggest insurers, would rather accept the world's lowest bond yields in Japan than buy U.S. debt.

``It's too early to say the dollar will stop falling,'' said Masataka Horii, head of the investment team in Tokyo for the $53.1 billion Kokusai Global Sovereign Open, Asia's biggest bond fund. ``The U.S. economy will be slow for a while.''

Japan owns more Treasuries than any other nation. After raising their holdings by $9.2 billion to $620.6 billion between March and July 2007, Japanese investors trimmed that stake by $34 billion through February, the Treasury said April 15.

America relies on foreign investors, who own more than half the U.S. government debt outstanding, to finance a deficit that New York-based Goldman Sachs Group Inc. predicts will expand to a record $500 billion for the year ending Sept. 30, after a $163 billion gap last year. Without their support, long-term interest rates would be 0.9 percentage point higher, a 2006 Federal Reserve study found.

In Thursday's market summary, IBD noted that inflation concerns were taking their toll on prices:

With oil prices approaching the $120-per-barrel mark and soaring food costs, worries about inflation hit the longer end of the bond market. The benchmark 10-year Treasury note yielded 3.74%, up from 3.71% late Tuesday.

Longer-dated bonds are among the most sensitive investments to inflation expectations, since rising prices diminish the cash flow from fixed income and erode the overall value of the investment over time.

"The market is worried about inflation — that seems to be new story," said Thomas di Galoma, head of government trading at Jefferies & Co. in New York.

The market is not the only one worried about inflation -- the Federal Reserve may actually be more concerned about that now.

The Federal Reserve is likely to cut its short-term interest rate by a quarter of a percentage point next week -- but then may be ready for a breather.

The Fed, meeting Tuesday and Wednesday, is likely to make what would be its seventh cut in eight months. The reason: Some officials see a case for more insurance against a deeper recession.

But others are concerned a cut could contribute to inflationary pressure with little benefit for growth. That means the option of standing pat will likely also be on the table. If it does cut rates, the Fed could signal in the statement accompanying the decision an inclination to pause and assess the impact of its cuts, which have lowered the federal-funds rate to 2.25% from 5.25% since last year.

Officials say the case for lowering rates further rests primarily on the value of additional insurance against a worse-than-anticipated economic scenario.

Here are three charts of the year over year change in three inflation levels -- CPI, PPI and Import prices.

The year over year change in CPI is hovering around 4%.

PPI's annual YOY change is running at around 7%.

Import/Export prices are increasing to 8% YOY.

So, we have the following points to keep an eye on.

-- Inflation is heating up and will probably impacting bond traders sentiment for some time

-- Because of a high deficit, there will be a big supply of Treasury bonds hitting the market. Increased supply means there will probably be upward pressure on interest rates

-- There is growing speculation the Fed is nearing the end of rate cuts. That may lead to increased rates as well.

-- Traders are selling Treasuries and moving into riskier assets.