Bond Market Commentary
Party Like it’s 1998
By Benjamin Streed
May 14, 2012
As of Monday morning, the 10-yr Treasury yield remains near a 7-month low as concerns out of the Eurozone continue to encourage the “risk off” trade that finds traders moving towards the perceived safety of U.S. Treasuries and German Bunds. Yields declined across the curve last week, with the 5-yr -3.7bp (0.746%), the 10-yr -4.1bp (1.838%) and the 30-yr was off 6bp (3.103%). For the sake of comparison, the 5-yr yield hasn’t closed at this level since January 31st, while the 10-yr yield is at its lowest level since October and the 30-yr long-bond, which is influenced more by long-term inflation expectations, is at its lowest since early February. Germany, which is also seeing a flight into its government securities due to its perceived safety, saw its 10-yr and 30-yr benchmark securities hit record low yields of 1.43% and 2.09% respectively. The chart below highlights the change between the Germany 10-yr Bund yield and a basket of credit default swap (CDS) contracts on European sovereign debt as indicated by the 5-yr Markit iTraxx SovX Western Europe Index. The CDS index increases as the risk of default by one or more of the included sovereign credits rises and includes the 15 members of the EU plus Denmark, Norway, Sweden and the United Kingdom.
Last week marked a historic run for the 10-yr Treasury note as it completed its eighth consecutive weekly advance. This marks the longest stretch of weekly gains for the security since October 1998 when Russia allowed its currency to depreciate and delayed payment of some of its debt which jarred markets around the globe. The current situation in Greece is an interesting parallel to what happened with Russia thirteen years ago as the potential for a possible Greek exit from the Euro and additional default not only rattles markets at home, but also spills into markets abroad. On Monday, Euro finance ministers are scheduled to meet in Brussels to discuss yet another bailout for Greece and the group insists that they are not considering easing terms of the original IMF/European Commission bailout despite the country’s persistent troubles. Officials are seriously beginning to consider the possibility of Greece leaving the Euro as politicians in Athens remain unable to form a government that will adhere to the austerity terms the country must adhere to as part of its agreement. Also important will be finding a way to bridge the divide between German Chancellor Angela Merkel and newly elected French President Francois Hollande who are set to meet in Berlin on Tuesday. Chancellor Merkel believes that further austerity measures in Greece are the most appropriate reaction to the country’s ailments instead of allowing the country to continue borrowing additional funds to spend its way out of its troubles.
Thanks in part to the uncertainty emanating out of Europe, inflation expectations here in the U.S. seem to be easing ahead of Tuesday’s CPI figures. The difference in yields between the 10-yr Treasury note and similar maturity Treasury Inflation Protected Securities, known as TIPS, fell to 2.13%, its lowest level since early February. The difference in these yields is often used as a measure of traders’ expectations for consumer prices over the life of the debt. According to a Bloomberg survey, economists are expecting that the consumer price index rose 2.3% last month (year-over-year), which is down significantly from the 2.7% reported last month and well off its recent high of 3.9% last September.
The End is Near
By Zach Berg, CFA
May 07, 2012
Not to worry; the foreboding title to this week’s bond market commentary has nothing to do with apocalyptic ends, but references the homestretch the Fed is in as it enters the last two months of its scheduled Operation Twist purchases. This week’s commentary examines the impact of those purchases and potential implications for the fixed income markets when those purchases end next month, but first, to the week that was.
Heading into last week, investors and traders alike knew Friday’s payroll figures would be the main event. Trading throughout the week leading into Friday was fairly measured with 10-year Treasury yields remaining in a 6bp range, equities moving fractionally lower, and corporate CDS spreads roughly 1bp higher, as of Thursday’s close. Expectations towards the jobs data grew more pessimistic as the week passed, especially after Wednesday’s poor ADP employment report. As it turned out those concerns of a potential miss were justifiable. The April headline nonfarm payrolls figure came in at 115,000 versus median Bloomberg expectations of 160,000, private payrolls arrived at 35,000 lower than expectations at 130,000, and the unemployment rate dropped to 8.1%. However, the falling in the unemployment rate was largely attributable to a reduction in the labor force participation rate to 63.6%, its lowest levels since December 1981! On the positive side, February and March jobs figures were revised higher by a combined 53,000. The concerns last month that the unseasonably warm winter would result in a skewing of the seasonal tweaks in economic data appear to have been justified as well. Raymond James Chief economist Scott Brown stated as much, “This was an unusually mild winter. As a consequence, the December-to-January decline in unadjusted payrolls was lower than usual and the February payroll gain was higher than usual. The seasonal adjustment turned these into outsized gains in January and February. The March and April payroll gains, in turn, were biased lower.” As the charts below display, the labor markets continue to be mired in a historically uncommon and challenging predicament, as discouraged workers increase and leave the labor markets as a result of structural shifts in employment. Surprising to no one, there remains a vast amount of room for improvement to return to a labor environment comparable to what people had grown accustomed to during past 40 years.
Although one bad jobs print does not necessarily equate to an impending trend of poor employment growth, and in fact the markets at first reacted positively to the jobs report based on the upward revisions, the second month in a row of a jobs report miss and a déjà vu feeling harkening back to last year had risky assets unsettled. The Dow Jones Industrial Index fell by 168 points, while 10-year Treasury yields tested and broke through the resistance level of 1.88%, closing just below the level. In overnight trading Sunday evening into Monday morning, 10-year yields were pushed all the way down to 1.8228%, as Japanese investors had their chance to react to Friday’s data, after being on holiday last Thursday and Friday. The 1.7971% closing low on 10-year Treasury yields posted back on January 31st serves as a key resistance level for investors to follow throughout the upcoming week.
Will the end of Operation Twist pressure long-dated Treasury yields?
After seven months of conducting their maturity extension program, otherwise known as Operation Twist, the Fed moves into the last two months of the operation, which is scheduled to be completed on June 30th. When the Fed finishes up next month, the Operation Twist program will have removed approximately $510bln in 10-year equivalents of duration from the market composed of $400bln in Treasuries and another $110bln in mortgage reinvestments. The Fed will also have accounted for a staggering 90% of gross purchases on the long-end of the curve. On the surface the removal of such a large buyer of Treasuries may increase anxiety amongst investors that yields will rise; however, a more thorough examination of the Fed’s activity displays that the answer is not quite that simple.
A Fed study conducted by Stefania D’Amico and Thomas B. King entitled “Flow and Stock Effects of Large-Scale Treasury Purchases,” examined the 2009 Treasury purchases conducted during QE1 and details their estimations of the effects those purchases had on Treasury yields. Based on their research, they found that the specific portion of the curve the Fed bought led to a decline of roughly 3.5bp in the corresponding Treasury yield on the day of the purchase. This is known as the “flow effect.” On the other hand, the cumulative effect of the purchases , or the “stock effect,” was found to have a much larger impact to the tune of reducing Treasury yields by 50bp overall. Recall that QE1 was much larger than QE2 and Operation Twist, as the Fed removed $850bln in 10-year equivalents, thus applying the figures above to the scale of Operation Twist equates to Treasury yields being 30bp lower as a result of the “stock effect.” Using this methodology for the “flow effect” translates into a very minimal impact that the Fed’s daily purchases have actually had on moving yields lower. This appears to have been the case when observing yield movements on days the Fed has conducted purchase activities. Combining these two components, one would garner that if the Fed study holds true, the end of Operation Twist should have a very minor impact and may not necessarily result in an overt amount of pressure for the long-end.
Outside of the actual effects the Fed’s purchases have had in removing duration, another factor that may lessen the blow of the conclusion of Operation Twist is that unlike the end of QE1 and QE2, the Fed now provides future rate guidance. By providing the markets with this information, there is a much clearer understanding of the Fed’s projected hiking path, as opposed to previously when the markets assumed that the Fed’s bias would turn towards tighter monetary policy. These presumptions led to investors moving their expectations of future rate hikes forward upon the completions of the easing programs and consequently resulted in higher Treasury yields. There remains seven weeks to go until the scheduled completion of Operation Twist and based on the evidence above the completion of that program may not result in too much Treasury market disruption. It appears that the amount of future QE pricing that becomes factored in Treasury yields may serve as a far greater influence and dynamic on which direction the long-end of the Treasury curve moves.
What’s Really Changed?
By Benjamin Streed
April 30, 2012
To put it simply, Treasuries were a bit of a rollercoaster last week; they rallied Monday, had a prolonged selloff on Tuesday and Wednesday, changed course with a rally on Thursday and then remained flat on Friday to end the week effectively unchanged. The choppiness we saw last week is not attributable to only one factor, but rather is a mixture of domestic and international economic factors mixed with commentary from various international monetary authorities. Monday’s rally revolved around the concerns that Spain’s deficit will pose a contagion threat to the ongoing Eurozone sovereign debt crisis as the country continues to face ever-increasing borrowing costs. Tuesday saw a slight reversal, after Spain was able to sell €1.9 billion short-term debt, helping to assuage some fears in the region. The selloff in Treasuries that day came despite weak economic data here in the U.S. in the form of anemic durable goods orders that missed expectations; headline -4.2%, ex-transportation and ex-air -1.1% and -0.8% respectively. Wednesday’s selloff revolved around the Federal Open Market Committee’s (FOMC) latest minutes which highlighted the ongoing need to provide accommodative monetary policy due to ongoing headwinds facing the U.S. economy, which led some market participants to believe that further Quantitative Easing (QE) may not be off the table. Thursday, the Treasury was able to sell $29 billion of 7-yr notes at a record-low yield of 1.347%, beating expectations for 1.357% on a strong bid-to-cover ratio of 2.83. Friday morning, S&P downgraded the sovereign credit rating for Spain by two notches to BBB+ on growing concerns that the country’s debt could continue to rise in conjunction with weak economic growth and high unemployment. The ratings agency’s primary concerns were, “The deterioration in the budget deficit trajectory for 2011-2015, in contrast with our previous projections” and “the increasing likelihood that the government will need to provide further fiscal support to the banking sector”. Helping calm the markets, Spanish Economy Minister Luis de Guindos commented that when it comes to bailing out the country’s banks and financial institutions, “We don’t need it”. After all this back-and-forth, “risk on” then “risk off”, Treasuries finished the week little changed: 2-yr -.6bp (0.257%), 5-yr -1.7bp (0.825%), 10-yr -2.8bp (1.934%) and the 30-yr long-bond -.16bp (3.122%). What’s really changed? The European debt crisis continues to lead market sentiment towards “risk on” or “risk off”, we still know that the Fed remains committed to provide accommodative monetary policies due to mixed economic data here in the U.S. and it appears we could have a continued run of “business as usual” until something unexpected comes along.
Spain in Distress
A very interesting note out of the Bloomberg on Thursday highlighted the potential implications for Spain’s credit rating given the current level of the country’s Credit Default Swap (CDS) contracts. Their unique process begins by calculating a composite credit rating for each sovereign issuer that is based on the average ratings provided by the three primary ratings agencies (Moody’s, S&P and Fitch). A score of 1 indicates the highest rating across all three agencies and a score of 10 or less indicates an investment-grade rating. Spain’s current composite rating of 6.3 is equivalent to an ‘A’ rating by S&P. Across the horizontal axis in the chart below is the cost of a 5-yr (CDS) contract, which is the amount that traders are willing to pay in basis points to protect €10 million the country’s debt against a default. For example, a quoted price of 100bp would indicate a yearly premium or cost of €70,000 per year. To summarize, moving up and to the right indicates that a country’s debt is perceived as riskier, while moving down and to the left indicates a less-risky profile. The current cost of protecting Spanish debt for 5-years rose to 475bp, which Bloomberg indicates is more than 200bp higher than Turkey, which is below investment-grade according to the composite ratings. The CDS-Implied rating on the country could potentially place the investment-grade status of Spain at risk going forward. Early Monday morning, S&P placed a large number of Spanish banks on review for potential downgrade after the country reported that GDP shrank for a second consecutive quarter, marking its second recession since 2009.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.
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