Re-Evaluating the Rates Landscape
By Zach Berg, CFA
March 26, 2012
Whether in the natural world or in the financial world, seismic shifts often catch individuals off guard, especially when the shift is a one-sided affair as was the case in Treasuries over the past two and half weeks. Consider that from March 6th-March 19th, 10-year Treasury yields posted their 5th greatest percentage increase in the past 3 years, in which yields moved 43.5bp higher. Likewise, it was the 2nd largest percentage shift in 5-year yields (37bp) and 4th largest change in 7-year yields (41.9bp). After snapping their nine day losing streak on Wednesday, the disappointing Chinese and European manufacturing data released Thursday really dampened risk sentiment, turning the tide for Treasuries and helping bring yields lower across the entire curve into the weekend. Following such a repositioning of rates, this week’s commentary takes a look at a few potential factors both positive and negative that may define the direction and the next potential trading range for Treasury yields.
Risk Factors to Higher Rates
- The greatest most likely driver to higher rates is the most obvious, improving economic data. With Greece moved to the backburner after the completion of their debt restructuring, at least until projected elections at the end of April, March 9th’s employment report added to the optimism that the US is on the path to a sustainable economic recovery. The acknowledgement of improvement from the Fed in March’s FOMC statement and subsequent speeches has only boosted hope and led to a considerable re-pricing of Fed rate hikes. (Based on Fed funds futures, traders in a manner of 7 weeks have moved up their expectations of the first rate hike to 3Q 2013 from 2Q2014.) In a Bloomberg monthly survey conducted this past week, 34% of respondents thought the economy was improving, which is the largest amount since January 2004. Helping boost that sentiment is weekly initial jobless claims figures which continue to show moderate improvements off of only marginal revisions, as the four-week moving average of claims has fallen to its lowest levels since March 2008. This progression on the weekly figures has economists predicting 225,000 additional job gains for March’s data, set to be released on April 6th. Another plus 200,000 monthly increase would be the third month in a row, matching a similar three month stretch of +200k gains witnessed in Feb-April 2011 and March-May 2010.
- A continuation of job growth supplemented by expansion in other economic data that pressures rates higher brings in a second potentially large dynamic in the form of mortgage convexity risk. The mortgage backed bond market’s exposure to the risks of prepayments and extensions based on the levels of interest rates and the sheer enormous size of the market requires active hedging techniques amongst MBS bond players. In a basic illustration, as Treasury yields (10-year yields specifically) rise, mortgage back hedgers would need to sell duration, through swaps or actual Treasuries, under the notion that homeowner prepayments will slow, hence an extension to the average life of the MBS security. When Treasury yields experience significant shifts in either direction, these hedgers must readjust said hedges in fairly large one-sided transactions exacerbating the directionality Treasury yields are already experiencing. The key level to watch for will be 2.4% on 10-year Treasuries. This significant level of support was established in late October last year and serves as the recent 10-year trading range’s Alamo. A break above this level and subsequent mortgage convexity selling could send 10-year yields another 30bp higher, according to Bank of America/Merrill Lynch research.
- Anecdotally, as discussed in the 2/13/2012 Bond Market Commentary, from mid-February through May, Treasuries have historically experienced higher yields during this seasonal time of the year. Thus, the historical predisposition is for Treasury yields to rise during the next few months.
What would push rates lower or keep them in their current range?
- Take everything mentioned under the first bullet point on job growth and economic improvement and recall that we’ve been here before only to see the data turn south taking with it Treasury yields. A strong argument has been made that the unseasonably warm weather, fourth highest average winter temperatures since 1890, has helped pull forward many of the positive effects warmer weather seasonally has on economic releases in the spring months. The direction of better than expected economic surprises has been moving lower, evidenced by the drop in the Citigroup US Economic Surprise Index from 83.70 on February 2nd to 27.40 this past week, equating to early November 2011 levels. It cannot be understated that the direction of economic data will be critical as we move towards the end of the Fed’s Operation Twist program in June and based on the expectations that it will need to be positive directionally to offset the mindset that US is set to encounter lower growth in the second half of this year and into the next.
- At the end of 2012 to the beginning of 2013, the US is set to experience a substantial fiscal tightening based on the expirations of the Bush tax cuts, the spending sequestrations (the cuts to discretionary spending that Congress agreed to during the debt ceiling debate), and expirations to both long-term unemployment benefits and the payroll tax cuts. In total, Barclays Capital estimates that the US may experience a tightening of $670bln in the 2013 calendar year. It is not expected that the US will face the entire burden of these cuts as politicians, although deeply partisan, will attempt to find compromise and cushion some of these blows. However, with it being an election year, tackling these issues sooner rather than later will be important to avoid attempting to pass these measures during lame duck sessions of Congress in November and December.
- Although it appears Greece concerns have been kicked far enough down the road (again late April), the re-emergence of European sovereign fears remains a problematic obstacle. The concern that more European debt restructuring may be needed resurfaced this past Wednesday, when Citigroup Chief Economist Willem Buiter being interviewed on Bloomberg radio discussed how he felt Portugal faced a very high probability of debt restructuring next year, and that Spain is at its “greatest risk of sovereign restructuring than ever before.” From a trading perspective, the elevation of these fears translated in to a sharp decline in German Bund yields, which witnessed 10-year yields fall from an intraday high of 2.07% Wednesday to 1.85% on Friday. A Euro zone economic recession in and of itself may not be a factor on suppressing domestic yields, but a risk sentiment shift over concerns that more messy debt restructurings may materialize would be a different animal reintroducing a bid for Treasury demand. European leader will look to quell some of these fears this upcoming week when they begin a two-day Euro zone financial meeting with the hopes of increasing the size of the two European bailout mechanisms.
- While a European economic recession may not overly affect US rates on its own, couple the slowdown in the Euro bloc with the prospects that China may face a harder landing than previously expected and the global economic growth backdrop shifts considerably more negative. Mentioned above, the fall in the preliminary HSBC Flash China Manufacturing Index to a four month low of 48.1 was a significant catalyst to helping boost Treasuries on Thursday. It was the fifth consecutive month that the index posted a below 50 print, with 50 representing the baseline for manufacturing growth. A release above 50 signifies growth, while a print below equates to contraction. Adding to the Chinese concerns have been recent weaker than expected auto sales and the story this past week from BHP Billiton stating they were seeing flattening iron ore demand from China.
From a technical perspective, after having the late February/early March bias appear to indicate that rates may face near-term selling pressure, which manifested itself in the nine-day sell off, the bias now appears to be neutral. That neutral bias may mean that any of the factors above have the potential to swing rates one direction or another over the upcoming few weeks. Although the items discussed above can make an argument for yields to coalesce near current levels or move slightly lower, the weighty catalyst needed to drive yields significantly lower does not appear to be present at the moment, while the historical levels of yields would indicate that the upside risks are much greater. On the flip side, a considerable readjustment of rates higher may defeat the Fed’s goal to maintain a relatively low nominal rate environment to help heal the housing market and promote the attractiveness of riskier asset alternatives, thus it would not be entirely surprising that a rampant increase in rates would be met by Fed “jawboning” to keep rates somewhat in check. This “jawboning” could be in the form of downplaying the economy and inflation expectations, while also discussing further quantitative easing after those expectations have fallen fairly dramatically over the past two weeks. Unfortunately, no one can say with any certainty what levels the Fed would like to keep rates in, meaning investors should remain cautious and diligent in adding long-dated duration in an environment of increased interest rate risk. In the week ahead, the economic calendar is highlighted by heavyweights such as Durable Goods Orders, Personal Income and Spending, and consumer confidence figures. Additionally, the Treasury will auction off $99bln in 2-year, 5-year, and 7-year notes. Look for technical levels of support and resistance below as a guide as Treasuries attempt to establish a new trading range during the upcoming weeks against this new rates backdrop.
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