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Trade Desk Thoughts:
Bond Markets Signal Fed Headache
The Dow Jones index recently hit 13-month highs, the dollar index reached 15-month lows, gold is trading at an all time high, but the Treasury market does not fit in this picture very well at all.
The Treasury market is used by investors in times of uncertainty, as investors take short positions in the equity markets and invest in the (relative) safety of the bond and Treasury market. This was clearly seen during the credit crisis, when the global stock markets were tumbling at an incredible pace, and at the same time, the Treasury market saw strong demand.
As the credit debacle unfolded, the yield 10-year Treasury notes tumbled from 5.1% down to 2.20% in just a few months, due to the inverse relationship between Treasury’s price and yield.
However, since March, the equity, commodity and currency markets started a strong recovery phase, but the Treasury market missed most of it. Moreover, the yield on the Treasury notes hit a yearly high in June, of 3.85%, and since then, the market had been trading most of the time in a range-bound fashion. The inverse relationship with equities has been challenged.
The Treasury market’s inability to advance is quite interesting, since the financial market expects the Federal Reserve to raise overnight and discount rates over the coming quarters, which would automatically send bond yields higher.
Usually, when the Treasury market stays at such low levels and fails to follow the rally seen in the other classes of assets, as in equities, it is because investors believe that the market is still in a risk-aversion mode; there is still elevated risk levels in the overall market.
Judging from the 60% rally seen in the Dow Jones index and from the gains seen in the commodity markets it is hard to say that the market is still in a risk-aversion phase.
The question this raises is what is keeping the Treasury market at such low levels, even though the market seems eager to put risk onto its balance sheets? These are unique times, and ones that are creating new rules to play the global risk game by, and as such the historical links that have bound markets will be challenged.
The signal here is that the equity run may need an infusion of speculative interest to keep things humming along, because the risk market is saying that bonds are offering just as much potential as stocks, at the levels that we are seeing right now.
At a time that the Fed is absorbing new notes being printed by the Treasury, so that the Stimulus packages can be put into action and cash created to invest as the Administration wishes, the automatic response is for 10 year yields to rise. The 10-year Treasury note has the greatest impact on the U.S. economy due to its influence on long term interest rates.
While the Federal Reserve controls the overnight rate, interest rates paid on long term financing for capital goods, as well as the housing market, are established by asserting a premium over the 10-year Treasury Note. In other words, whatever the 10 Year Note is worth determines the rates for mortgages, investments and loans that are set from that starting point.
There has been no public announcement of any exit strategy, or to try to unwind the ever-increasing yield (read mortgage, credit card, auto, commercial real estate, borrowing costs). The elevated yields have created massive spreads in the value of insuring against default on the notes (read credit default swaps), and the cost of banks doing business with each other (read LIBOR, the London Inter Bank Offered Rate), that are only now coming together.
The Fed did its job in creating global liquidity, the Treasury is doing its job of creating government debt and generating cash, and the market did its job of buying equities that were backstopped by the Fed and regional central banks. Now that quantitative easing has to be priced in to forward valuations, U.S. Treasuries that virtually guarantee a 3.5% rate paid over each of the next ten years may seem cheap.
Take out the cost of insurance that the U.S. government stays solvent, and it may be easily seen why, as earnings season comes to an end, and with massive U.S. note auctions, the Usd may start to get bought.
Another relationship of note (no pun intended) is between the Treasury bond’s price and the interest rate or premium it offers at any time. It is an inverted relationship; when bond prices increase the yield (interest rate) moves lower, and vice-versa. This all comes from the fact that at maturity repayment of the principle is paid at par value, and not at bond’s market price. Par value = Current Interest Rate/Price
-A $1000 10 year Treasury Note with a 4% Interest Rate; $1000 x 4% = $40 guaranteed a year, for 10 years
-If the market price of the note goes down, because of increased amount of notes hitting the markets, to $500 for example, then the interest rate math changes because the same $1000 bond with a 4% interest rate is still guaranteed to pay 4% a year.
-Now that it has an open market value of $500, and still returning $40, the interest rate, or Par, is now 8% for as long as the note value holds $500.
After these results, it is pretty clear that the best way to trade bonds is usually during recession times, when bond prices increase due to repeated rate cuts, and in times of equity selling. The variable here is the unknown exit strategy for the Fed to contain interest rates, and that is creating fear of loss and Treasury volatility that has no release valve outside of the Fed raising interest rates.