The Yield Curve is Flattening?

Wednesday, December 17th, 2008

Long-term government bond yields are dropping everywhere. Is anybody going this way?

Here is what some of the folks in the bond market are saying:

Eric Lascelles, Chief Economic and Rates Strategist,  TD Securities Inc.: “It is remarkable, the speed at which this is happening,” said Eric Lascelles, chief economics and rates strategist for TD Securities Inc.

Stewart Hall, currency and fixed-income strategist with HSBC Securities (Canada) Inc.: “I think one of the overarching themes today is global recession.” On a positive note, “You have the Fed and other government agencies operating in an imaginative and innovative fashion to throw as much as necessary [at the problem] to get the economy back in track.”

Mark Chandler, fixed-income strategist with RBC Dominion Securities Inc.: “Long-term rates are playing catch-up in terms of the decline in yields we have seen in short-term bonds.  There is limited downside in short-term yields.”The relatively greater drop in yields on long-term bonds compared with short-term bonds is a theme that could continue into the first half of 2009, Mr. Chandler said. In the parlance of bond traders, this is known as a yield curve flattener, as the difference in yield between short-term and long-term bonds narrows.

The decision by the Fed last week to buy $500-billion (U.S.) of agency guaranteed mortgage-backed securities, along with $100-billion of other agency (government-sponsored enterprises) debt, is a force acting to push yields down.

On an increasing basis, the Fed has been taking steps to manage through the U.S. housing crisis. The plan injects liquidity into the system, and frees up cash available for mortgage lending, as well as serving to lower U.S. mortgage rates. The rate of 30-year mortgages has fallen to 6 per cent last week from 6.5 per cent.

Less than two weeks ago, Federal Reserve Board chairman Ben Bernanke indicated that the Fed could also decide to buy longer-term U.S. Treasuries, which would reduce bond supplies, resulting in higher prices and a decline in yields.

From Bloomberg:

The 10-year note’s yield fell as much as 14 basis points, or 0.14 percentage point, to 3.37 percent. It traded at 3.40 percent at 3:04 p.m. in Toronto. The price of the 4.25 percent security maturing in June 2018 advanced 84 cents to C$106.86.

The yield on the two-year government bond dropped six basis points to 1.77 percent. The price of the 2.75 percent security due in December 2010 rose 12 cents to C$101.95.

The 10-year bond yielded 163 basis points more than the two- year security, down from 168 basis points yesterday. The so- called yield curve reached 184 basis points on Nov. 6, the steepest since May 2004.

Our thoughts are that Government of Canada bond yields which are still higher than those of comparable US treasuries will also come down over the next year, as investors seek the refuge of government securities (and Canada’s higher yields), on the Canadian as well as global recession trend. The current blows to the Canadian economy come as the Auto industry copes with the difficulties of the Big Three automakers, and in the commodities sector, with the decline in commodities prices that has led producers to consider shutting in mining and exploration projects, and laying off employees. On this basis, it seems far more likely that Canada’s yield curve could continue to flatten along with the US treasury yield curve, leading to higher bond prices and lower yields.

Levente Mady, a fixed-income strategist at MF Global Canada Co.: “Inflation doesn’t matter any more. It’s deflationary concern that’s underpinning the bid in the long end of the market. Yields are literally gravitating towards zero. It’s almost like it doesn’t matter if the news is good, bad or indifferent.”

Sources: Globe and Mail, Bloomberg

Tags: Array, Ben Bernanke, Bond Traders, Bond Yields, Canada, Canada Inc, Federal Reserve Board, Federal Reserve Board Chairman, Global Recession, Government Bond, Government Sponsored Enterprises, Hsbc Securities, Lascelles, Mark Chandler, Mortgage Backed Securities, Other Government Agencies, Rbc Dominion Securities, Rbc Dominion Securities Inc, Td Securities Inc, Term Bonds, Term Yields, Yield Curve
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Stock Markets: Is This It?

Wednesday, December 17th, 2008

The US Federal Reserve yesterday pulled out all the stops in a frantic effort to save the US economy from collapse and stem the deflationary forces. The Fed funds rate was slashed from 1% to a target range between 0 and 0.25% – the lowest the central bank’s key rate has been since records began in 1954.

In reality, the Fed is simply aligning its target rate with the effective rate and thereby pushing monetary policy into an era of Zirp, i.e. a zero-interest-rate policy.

The Federal Open Market Committee’s (FOMC) statement said the “outlook for economic activity has weakened further” from its previous meeting in late October, indicating that the “Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability”. The statement also discussed specific actions that would move the Fed further toward quantitative easing.

In my opinion, the Fed’s communiqué in reality signalled the large-scale monetizing of the US debt markets.

Hat tip: Mish, Global Economic Analysis

Sharing my sentiments, Bill King (The King Report) commented: “Ben Bernanke and the Fed just screwed everyone in the US, and some abroad, that played by the rules, was prudent and live on fixed incomes. Ben, just like Easy Al, is once again redistributing wealth from the prudent, the savers and retirees to the reckless and the boobs that created this mess. But the Fed, via its communiqué, is admitting that it is petrified of what is occurring in the economy and financial system so it is now in all-out money/credit dump mode.”

An e-mail just received from Bennet Sedacca (Atlantic Advisors Asset Management) said: The “Fed has declared war on prudence and savers and rekindled the ‘Moral Hazard Card’ – except this time, I believe they have created the largest moral hazard ever seen. Of note is that this intervention has occurred in the third week of the month (options expiry for the greatest impact – playing games with an already dysfunctional system that they created) and may force prudent, risk-avoidance types, to take risk, at precisely the wrong time.

“I respect markets, and will not sell short against this force that seems invincible, but as always, will remain cognizant of the Big Picture, one that Bernanke and Co. cannot see, it seems. In fact, it feels like they are making a mockery of our system, that they are desperate and will print enough dollars that will force other central bankers to do the same.

“With stated short-term interest rates at 0 (and likely to stay there for the foreseeable future), 30-year Treasuries at 2.7% and stocks at gargantuan price/earnings ratios, we will look to continue to protect our investor’s capital as we have done to date. I do not like being forced into a game of ‘Liar’s Poker’.”

With Treasuries and agency debt potentially subject to a great deal of price risk at these levels, and the US dollar appearing to be topping out, where does the Fed’s “betting the ranch” policy leave the stock market?

Firstly, for some historical perspective, the MSCI World Index and the MSCI Emerging Markets Index have improved by 18.9% and 23.2% respectively since the November 20 lows. As far as the US markets are concerned, the Dow Jones Industrial Index has gained 18.2% since the low, the S&P 500 Index 21.4%, the Nasdaq Composite Index 20.8% and the Russell 2000 17.1%.

In addition to the Fed’s attempts to inflate asset prices, there are a number of short-term positives for equities.

(1) The period post Thanksgiving through the end of the year has usually been a bullish time for stocks, based on studies by Jeffrey Hirsch (Stock Trader’s Almanac).

(2) With the exception of the Russell 2000 Index, all the major US indices yesterday breached their 50-day moving averages. Should the bullish seasonal tendencies provide a further tailwind, the next targets for the various indices are the November 4 highs and the key 200-day moving averages, as shown in the table below. On the downside, the December 1 lows (not shown in the table) must hold for the rally to remain intact.

The number of S&P 500 stocks trading above their respective 50-day moving averages has increased to 53.4% from almost zero in October. However, only 5.4% of the index constituents are trading above their 200-day lines.

(3) The CBOE Volatility Index (VIX) (green line) has declined from the 80s in October and November to 52.4 yesterday. It is not uncommon for short-term volatility to be at extreme levels at bottom turning points, and for stocks to improve as the “storm” grows quieter.

(4) I have mentioned in a previous post that “for a more lasting market turnaround to happen, I would like to see … a 90% up-day …” Yesterday was likely another 90% up day, the first since December 1. The Lowry’s figures are looking better and the Buying Power Index has just broken out above its declining trend line.

(5) Since the peak of the TED spread (i.e. three-month dollar LIBOR less three-month Treasury Bills) at 4.65% on October 10, the measure has eased to 1.83%. Although this measure is moving in the right direction, credit spreads need to narrow further to indicate that confidence is returning and liquidity is starting to move freely again.

(6) On a fundamental note, it is hard to get a grip on the “E” component of price-earnings multiples, but it will be remiss to ignore the fact that 39% of the constituents of the MSCI World Index sell at a discount to shareholders’ equity. “The cash-rich companies allow investors to pay nothing for future earnings streams,” said Jean-Marie Eveillard in an interview with Bloomberg.

(7) Markets have been shrugging off bad news since the poor ISM manufacturing and payrolls data of two weeks ago. I quoted Richard Russell (Dow Theory Letters) in my “Words from the Wise” review on Sunday, saying: “This is all the more dramatic since this potential upturn has arrived in the face of black-bearish news. Markets bottoming and rising in the face of bearish news are often the most profitable ones. I have never seen a bear market hit its low amid happy news headlines.”

Notwithstanding the improvement since the November lows, it remains too early to tell whether a secular low has been recorded. The chart below shows the long-term trend of the S&P 500 Index (green line) together with a simple 12-month rate of change (or momentum) indicator (blue line). Although monthly indicators are of little help when it comes to market timing, they do come in handy for defining the primary trend. An ROC line below zero depicts bear trends as experienced in 1991, 1994, 2000 to 2003, and again since December 2007.

Stock markets are still caught between the actions of central banks furiously fending off a total economic meltdown on the one hand, and a worsening economic and corporate picture on the other. The rally may have more legs, but failing further technical and fundamental evidence, I remain distrustful as to whether “this is it”.

Tags: Available Tools, Ben Bernanke, Bill King, Debt Markets, Deflationary Forces, E Mail, Effective Rate, Fed Funds Rate, Federal Open Market Committee, Fixed Incomes, Fomc Statement, Frantic Effort, Global Economic Analysis, Interest Rate Policy, Moral Hazard, Open Market Committee, Sustainable Economic Growth, Target Range, Target Rate, Zero Interest
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