Bond Market Commentary
The Fear Factor
By Zach Berg, CFA
May 21, 2012
AAs if listening to a broken record that has caused listeners a splitting migraine, Greece was once again the refrain that drove yields this past week with 10-year Treasury yields coming within just under 2bp shy of their all-time lows (1.671%). The inconclusive Greek national elections two weeks ago and subsequent inability of the main political parties to form a coalition government has led to the scheduling of new national elections on June 17th and increased risk apprehension that Greece’s exit from the Euro zone may become a reality. The contagion potential of a possible Greek Euro exit invoked the fear trade, with the Moody’s downgrade of 16 Spanish banks and a Wall Street Journal article (J.P. Morgan Struggles to Unwind Huge Bets) that the JP Morgan trading loss may reach $5 billion, only added fuel to the fire. Risk aversion skyrocketed leading to a flight to quality rally, in which 7-year, 10-year and 30-year Treasury yields fell 7bp, 11.5bp and 20bp respectively. For the second week in a row, German Bund yields fell to new record low levels for 2-year, 5-year, 10-year and 30-year Bunds, while Spanish 10-year yields soared, nearly hitting 6.5% on an intra-day basis Wednesday. The shunning of risky assets left equity prices lower once again as the Dow Jones has lost nearly 910 points since its May 1st 2012, high of 13,279 and the S&P 500 Index 2012 return has been depleted from what once was a 12.84% figure to just 2.99%. Following equities lead, corporate bond spreads were under pressure as well, with the Markit CDX NA IG 18 index of 125 investment grade credit default swap spreads blowing out over 14bp on the week and their corresponding cash equivalents jumping 20bp higher, according to the Citigroup Investment Grade Index. The JP Morgan effect coupled with European banking fears stemming from reports of potential bank runs in both Greece and Spain put bank and finance spreads under the greatest stress, evidenced by the astonishing 30bp widening in those spreads, based on Yield Book figures. Last week’s trading backdrop was all too reminiscently familiar for many investors, but after the capitulation of last week investors are left with near record low yield levels for many Treasury maturities, while the liquidity concerns that have dominated previous bouts of volatility have not reared their heads. This week’s commentary highlights four observations to these points worth noting during another episode of heightened market instability.
The Front-end of the Treasury Yield Curve did not join last week’s rally
The long-end of the Treasury curve has fallen dramatically led by 10-year Treasury yields falling roughly 12bp last week and 22bp since the start of May, while 30-year yields moved over 20bp lower last week and 31bp for the month. As the chart below displays, 7-year and 10-year yields are within an earshot of their lowest levels; however, 2-year and 3-year yields remain above their lowest yields and actually moved higher this past week even as risk aversion soared.
Why are front-end yields not moving lower? The answer may be from multiple sources including higher repurchase (repo) rates and the Fed’s Operation Twist program. Repo rates dropped precipitously in early 2011, evidenced by the fall in 3-month repo rates to just 0.01% in April and spent a majority of the year trading in rough 5bp range due to the excess amounts of available liquidity as a result of the Fed’s QE2 operation ($600bln) and money market mutual fund (MMMF) demand for repos. The 0.1532% 2-year low shown above corresponded to an approximate 0.03% 3-month repo rate in September 2011. The demand from MMMF’s has subsequently decreased leaving repo rates higher (3-month: 0.17%) and establishing a quasi floor for front-end yields. Another significantly important change was the supply and demand facets of the front-end, where the Fed’s decision to embark on Operation Twist has increased the supply of 3-month to 3-year Treasuries by $400bln upon completion next month. Until Operation Twist ends in June, it appears that this dynamic is unlikely to change leaving short-term yields depressed but above their all-time lows.
The Long-end of the yield curve moves closer to record low yield levels
As mentioned above, 10-year Treasury yields came within just 1.751bp (1.6886%) of their all-time low yield level of 1.671% witnessed back on September 23rd, 2011, and 30-year yields are just 30bp above their corresponding low. With long-end yields plunging over the past three weeks, the Relative Strength Index technical indicator is flashing an overbought signal for 10-year and 30-year yields. According to Bloomberg, the Relative Strength Index measures the velocity of a securities price movement to identify overbought and oversold conditions. The graph below highlights this technical condition for the 30-year where the RSI has crossed below the green line.
It is important to note that this is just one technical indicator and with risk sentiment skewed as negatively as it is at this time, a corresponding retracement higher in Treasury yields is not a given. In fact, when looking at the RSI overbought indications during times of great stress, such as last August (circled above), the sell signal of the index produced only a minor correct and did not resulted in longer term selling pressure. If risk aversion remains extremely elevated, Treasury yields can remain at near historic levels for 10-years or even move lower on 30-years. Also aiding the argument that any correction may be brief is the record low yield levels German bunds are hitting, which should help maintain a bid for Treasuries as well. The RSI is simply displaying that the recent rapid decline is yields may be primed for some sort of correction whether minor or something greater given the markets propensity of not moving solely in one direction. This week’s supply of $99bln worth of 2-year, 5-year and 7-year paper would be an example in which historically yields have built in a supply concession equating to some varying degree of higher rates to digest the new supply.
The Yield Curve is at its flattest levels in eight months
Combining the factors mentioned above and the overall shape of the yield curve is at its flattest level since October 2011. A disregard of the technical backdrop and a continuation in rally of 30-year yields could bring the yield curve back to its flattest state in three years.
Liquidity measures are not showing strains ... yet
Post Lehman, nearly all moments of market stress have been linked with increasing liquidity pressures, evidenced by increases in the TED Spread (3-month LIBOR less 3-month Treasury Bill) or the LIBOR/OIS Spread (Overnight Indexed Swap). On a positive note thus far, this has not been the case this time around due in large part to the extension of swap lines the Fed and other global central banks have put in place to keep the flows from being strained. Additionally, the two ECB long-term repurchase operations have placed a great amount of liquidity in the hands of European banks. It appears unlikely at this moment that liquidity will become a concern this time around; however, the addition of a liquidity dilemma to what has been a solvency problem would greatly exaggerate the current situation.
Investor psychology is a precarious thing as apprehension and trepidation have ratcheted higher during the past few weeks. The yield curve has flattened dramatically, while the dynamics at the front-end do not appear set to change in the near-term and the intermediate portion of the curve experiences increasing expectations of further Fed easing. Those expectations only grew this past week after the release of April’s FOMC minutes stated a shift from a “couple” members to “several” members of the Fed “indicated that additional monetary policy accommodation could be necessary if the economic recovery lost momentum or the downside risks to the forecast became great enough.” The domestic economic calendar is fairly light this upcoming week with exception of Durable Goods Orders on Wednesday, leaving whatever European breaking news headlines as potential market drivers. However, with the Greek elections roughly four weeks away and Spain struggling to stabilize its banking sector losses as its economy remains in a recession, it appears the fear factor dynamic is unlikely to alleviate anytime soon.
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.
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.
To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.
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