Economic & Bond Market Recap – June 30, 2010

By Rom Badilla, CFA – Bondsquawk.com

June 30, 2010

Following a report indicating weak corporate employment growth, U.S. Treasuries rallied led by the long-end of the curve as stocks sold off late in the last session of the 2nd quarter.

Economic Data

According to Automatic Data Processing, the private sector added only 13,000 employees to payroll in June, which disappointed forecasts as economists expected an increase of 60,000.  The May figures were revised upward by two thousand jobs to a total of 57,000.  Apparently, companies are still reluctant to add as the U.S. economy faces headwinds as evidence suggests a slowdown in economic activity.

Looking beyond the headline numbers, medium sized companies, defined as 50 to 499 total employees, added the most jobs from the previous month at 11,000.  Large companies, characterized as 500 or more employees, added only 3,000 from May while small businesses, defined as 1-49 total people, subtracted headcount by a thousand.

Given this data set, it appears that small businesses which many consider the fuel to sustainable and long term job growth are still reluctant to add new hires.  This is a result of either less access to credit which is needed for expansion due to too stringent loan conditions by lending institutions or waning demand for loans by small companies due to the uncertain economic outlook.

Job growth as reported by ADP is still anemic and may point to disappointing government figures, which is due for release this Friday.  Non-farm Payrolls is expected to decrease by 130,000 according to Bloomberg consensus surveys.  The Unemployment Rate is expected to tick up by a tenth of a percent from the last release to 9.8 percent.

Interest Rate Markets

After the massive leg down yesterday, U.S. Treasury yields declined on the long-end of the curve in a bull flattener.  The Long Bond outperformed the maturity spectrum by matching recent lows set in October 2009 and dropping 4 basis points to a yield of 3.89 percent.  The yield on the 10-Year Treasury declined 2 basis points to 2.93 percent.  The 5-Year ended bond trading on Wednesday at 1.78 percent, a slight increase of close to a basis point.  The yield on the 2-Year inched up a basis point as well to 0.60 percent.

30-Year U.S. Treasury Yield - Intraday Chart

Inflation expectations as indicated between the yield differential between the 10-Year Treasury and 10-Year Treasury Inflation Protected Securities (aka TIPS) continue to decline.  This differential, aka “the Breakeven Rate”, declined 2 basis points to 1.85 percent.  For the month of June, the breakeven rate is down by 21 basis points.

Inflation Expectations aka Breakeven Rate - Historical Chart

Across the Atlantic, government bond yields for the developed economies were generally mixed.  German 5-Year Bunds increased 2 basis points to 1.46 percent.  The yield on France’s 5-Year was unchanged on the day and closed at 1.98 percent.  5-Year U.K. Gilts rallied as the yield decreased 6 basis points to 2.06 percent.

Peripherals enjoyed a good trading session as government bond yields decreased, following statements by the ECB that they will lend to banks only 131.9 billion euros, which were less than expected suggesting that interbank lending is relatively healthy.  Greek 5-Year government bond yields declined 8 basis points to 10.84 percent.  The yield on 5-Year Portugal bonds tightened 10 basis points to 4.60 percent.  5-Year Ireland bond yields closed at 4.56 percent, a basis point decline while Italy’s 5-Year moved lower by 3 basis points to 2.98 percent.  Spain’s 5-Year dropped to a yield of 3.74 percent, a change of 5 basis points from yesterday’s close.

Spain Government Bond Yield Curve - Daily Change

Despite the decline in bond yields, Moody’s Investor Services said it placed Spain on review which should conclude in the next three months for a possible downgrade.  Currently, Spain government bonds enjoy the highest credit rating by Moody’s at AAA.  Today’s signal should place added pressure on tomorrow’s 3.5 billion euro 5-Year auction.  According to a Bloomberg report, Spain has nearly 25 billion euros of maturing debt in July.

Credit Markets

The credit bond markets were mixed against U.S. Treasuries.  The BofA Merrill Lynch High Yield Master Index widened 7 basis points to a spread of 713 basis points over comparable maturity Treasuries.  The U.S. Corporate Index which consists of over four thousand investment grade bonds was unchanged and closed at a spread of 209.  Similarly, the U.S. Bank Index finished at a spread of 274, a decline of 3 basis points.

Mortgage spreads widened relative to Treasuries suggesting rising borrowing costs for homeowners.  The yield differential between 30-Year Conventional Mortgage Backed Securities priced at par and the 10-Year Treasury increased 6 basis points to a spread of 82 basis points.  Though after all that is said and done, the spread has declined by 3 basis points in June.

30-Year Conventional MBS Spread over 10-Year U.S. Treasury

Across the Capital Markets

Stocks continued its downward descent as the major indices declined in the afternoon session, closing below recent lows.  The S&P 500 declined 1.0 percent and closed at 1030.71, which is below 1040, a widely accepted technical support level.  The NASDAQ dropped 1.2 percent to 2109.24.  The CBOE VIX Index increased 1.2 percent to close at 34.54.

The Dollar Index was mostly unchanged on the day at 86.019 as currencies across the Atlantic were mixed.  The Euro advanced 0.4 percent to 1.2238 while the British Pound lost 0.8 percent to 1.4945.

Gold spot prices gained modestly by 0.1 percent to 1242.25.

While the market is focused on the aforementioned release of Friday’s employment report, tomorrow’s economic data releases are important in determining the health of the economy.  Initial Jobless Claims for the week ending June 26 is expected to decline by two thousand from the prior week’s reading of 457k people.  Continuing Claims for the week ending June 19, is expected to increase slightly by two thousand to 4,550k.  In addition, the Institute of Supply Management will release its widely-followed manufacturing activity index for signs of the U.S. economy.  Economists expect a reading of 59.0 for June after a print of 59.7 in the prior month.  A reading above 50 suggests economic expansion.

Edited on July 1, 2010 for correction on Non Farm Payrolls survey.  The survey number was corrected to relfect a decline of 130,000 from an increase of 25,000.

Posted by Rom on June 30, 2010 under Bond Chatter,Bond Trading | | View Comments

Corporate Debt Issuance Declines, Cash Rises

June 30, 2010

Are corporations taking the same cue from households of reducing debt and increasing savings? It appears so as companies see fewer opportunities for economic growth which gives less reason to take out debt to finance expansion according to an article from Bloomberg.

Companies are selling the fewest bonds since 2004 as rising cash levels let borrowers weather concern that the global economy is slowing.

Offerings fell 39 percent to $1.17 trillion in the first half from the same period in 2009, according to data compiled by Bloomberg. The decline was led by financial companies, which issued 35 percent less debt.

Borrowers, with 15 percent more cash than a year earlier, are relying less on capital markets amid concern that Europe’s sovereign-debt crisis may slow the economic recovery. Corporate bonds are beating stocks by the most in nine years, returning 4.9 percent in the first six months, compared with the MSCI World Index, which is down 9 percent.

It appears that such a strategy is insulating high grade corporate bond performance as credit spreads remain subdued for the time being despite the recent decline in the stock market and subsequent spike in the CBOE Volatility Index (as mentioned here, correlations between the VIX and credit spreads are high).  In the last two days, the Merrill Lynch U.S. Corporate Index which contains over four thousand investment grade bonds widened just 2 basis points to a spread of 209 basis points over comparable maturity U.S. Treasuries while the S&P 500 lost 3.3 percent.

Read the Full Article

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Achuthan Expects Downturn in Global Economic Growth

June 30, 2010

As reported last Friday, the Economic Cycle Research Institute’s Weekly Leading Economic Growth Rate Index dropped further into negative territory signaling a slowdown for the U.S. economy. For the week ending June 18, ECRI’s Growth Rate Index dropped from -5.8 percent in the prior week to -6.9 percent. Lakshman Achuthan, managing director of the ECRI, talks with Bloomberg’s Susan Li about the outlook for the global economy.


(Source: Bloomberg)

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Doctor Doom Says Greece Should Default

June 30, 2010

In a Financial Times article published earlier this week. Noriel Roubini aka Doctor Doom suggested that Greece’s best option is to default.

It is time to recognise that Greece is not just suffering from a liquidity crisis; it is facing an insolvency crisis too. Rating agencies have started to downgrade its public debt to junk level, while spreads on Greek sovereign bonds last week spiked to new highs. The €110bn bail-out agreed by the European Union and the International Monetary Fund in May only delays the inevitable default and risks making it disorderly when it comes. Instead, an orderly restructuring of Greece’s public debt is needed now.

The austerity measures to which Greece signed up as a condition of its bail-out require a draconian fiscal adjustment of 10 per cent of gross domestic product. This would prolong the country’s recession and still leave it with a public debt-to-GDP ratio of 148 per cent by 2016. At this level, even a small shock is likely to trigger a further debt crisis. Sharp austerity may be needed – as agreed by the Group of 20 over the weekend – to stabilise debt-to-GDP ratios by 2016 in advanced economies; but for Greece such “stabilisation” would be at levels that are unsustainable.

Read the Full Article

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Headed for a Double-Dip?

June 30, 2010

Discussing what the double-dip recession tipping point is, with John Mauldin, Millenium Wave Advisors.


(Source: CNBC)

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Economic & Bond Market Recap – June 29, 2010

By Rom Badilla, CFA – Bondsquawk.com

June 29, 2010

As stocks tumbled around the globe fueled by economic indicators suggesting slowing growth, U.S. Treasuries rallied in a flight-to-quality trade.

The global sell-off began when the Conference Board stated that the leading economic index increased only 0.3 percent in April which was significantly less than the initial report of 1.7 percent from earlier this month. This sent shares in China’s Shanghai Composite Index down 4.3 percent to a new recent low of 2427.05. The drop abroad sent negative ripples stateside which was fueled even further by economic data releases suggest a slowdown in U.S. economic activity.

The Conference Board piled onto the bad news by releasing a disappointing Consumer Confidence Index. The Index came in at a reading of 52.9 versus economist expectations of 62.5, and after a revised prior period reading of 62.7. The disappointing release signals that people are less optimistic of the economy due to little improvement in the labor market.

As a result, U.S. Treasuries rallied across the curve led by the long-end of the curve. The yield on both the 10-Year Treasury and Long Bond declined 7 basis points to close the day at 2.95 and 3.93 percent, respectively. Today’s close on the 10-Year now stands at a one year low. The 5-Year closed at 1.77 percent, a drop of 5 basis points. The yield on the 2-Year tightened 3 basis points to 0.59 percent.

10-Year U.S. Treasury Yield - Historical Chart

Inflation expectations as indicated by the yield differential between 10-Year Treasuries and 10-Year Treasury Inflation Protected Securities (TIPS) declined 2 basis points to 1.89 percent. This breakeven rate has now dropped 56 basis points since the end of April.

Inflation Expectations - Historical Chart

Across the Atlantic, government bond yields were mixed. German 5-Year Bunds decreased 3 basis points to a yield of 1.44 percent while France’s 5-Year declined 7 basis points to 1.98 percent. The yield on U.K. 5-Year Gilts increased 3 basis points to 2.11 percent.

Peripheral bond yields mixed as well. Greece 5-Year bond yields decreased 7 basis points to 10.91 percent. Spain’s 5-Year increased 9 basis points to 3.79 percent while the yield on Portugal’s added 2 basis points to end at 4.69 percent. Italy’s 5-Year closed at 3.00 percent, unchanged from yesterday.

The U.S. credit markets also felt the heat of today’s action as spreads widened. The BofA Merrill Lynch High Yield Index widened 13 basis points to a spread of 706 basis points over comparable maturity Treasuries. The Investment Grade index widened a basis point to a spread of 209. The U.S. Bank Index increased 3 basis points to a spread of 277.

Merrill Lynch U.S. High Yield Master Index Spread - YTD Chart

As mentioned above, stocks tanked today. The S&P 500 declined 3.1 percent to 1041.24 while the Nasdaq dropped 3.9 percent to 2135.18. The CBOE VIX spiked 17 percent to 34.13.

The Dollar Index advanced 0.6 percent to 86.132. The Euro dropped 0.7 percent to 1.2188 while the British Pound declined 0.3 percent to 1.5067.

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Commercial Real Estate Borrowers Struggle to Payoff Maturing Debt

June 29, 2010

Commercial real estate borrowers whose loans were packaged as Commercial Mortgage Backed Securities, are having a difficult time paying off maturing debt despite some improvement in the availability of financing according to a Bloomberg article.  Borrowers are struggling to payoff their mortgages due to massive declines in commercial real estate values.  Furthermore, rising vacancy rates is having a negative effect on cash flows, which in turn, leads to higher delinquencies. 

Between 50 percent and 60 percent of loans on skyscrapers, hotels, shopping malls and apartment complexes failed to refinance within a few months of their maturity date this year, Bank of America Merrill Lynch analysts said in a report. That compares with 15 percent to 20 percent in 2008, according to the analysts led by Roger Lehman in New York. About $11 billion in loans, or one-third of the 2010 total, had hit their expected maturity dates through late May.

The amount of capital available to commercial property owners has improved dramatically over the past year, though it still falls short, according to the report. “The level of financing is not where it was, or even where it needs to be for a full commercial real estate market recovery,” the analysts said.

If borrowers cannot refinance or pay off their loans, they either default or persuade lenders to extend their maturities.

The likelihood of payoff comes down to the origination year of both the loan and securitization. Loans originated in the early part of this decade has a higher probability of payoff. Securitizations typically had conservative assumptions on the performance of the loans in order to “cushion” the blow to investors in case something negative occurred. Metrics such as low loan-to-values, high debt service coverage ratios, and conservative occupancy rates in determining future cash flow of the property were common to deals that were issued early on this past decade.

However, as loan origination started to decline, underwriting standards loosened in response in order to drum up loan growth. As a result, the quality of the aforementioned metrics dropped dramatically. This is starting to catch up to investors as loans originated late in the cycle such as late 2006 and all of 2007 are less likely to payoff, an indication that underwriting standards declined in the later stages of the real estate boom.

 

The biggest factor in whether a loan is able to pay off when it comes due is which year it was taken out, as loans written prior to the boom are more conservative. About 64 percent of loans originated in 2004 paid off, compared with 33 percent of those originated in 2005, the analysts said.

In the later stages of the cycle, interest only or IO loans gained popularity, sometimes comprising as much as 50 to 60 percent of the deal. IO loans, which is designed to minimize the monthly debt payment by delaying principal payment for borrowers as a tactic to enhance cash flow, is also less likely to payoff.

Some of the poorest-performing loans are those that delay principal payments through part of the term, the report said. Just 31 percent of so-called period interest-only loans paid off at maturity, compared with 38 percent of loans that amortized from the start, and 39 percent of loans that made no principal payments until maturity, according to the report.

The period interest-only loans are “less well underwritten, with higher leverage,” the analysts said. “The very short amortization period does little to reduce that leverage.”

A large number of loans with five-year terms taken out as property values soared and underwriting standards plummeted will come due during the next two years. More than $60 billion of the debt matures in 2011 and $80 billion in 2012, according to Bank of America.

Top-rated debt sold in 2007 yields 2.2 percentage points more relative to benchmark rates than similar bonds sold in 2005, reflecting the view that loans taken out as sales of commercial-mortgage-backed securities peaked are riskier, according to Credit Suisse Group AG data.

Read the Full Article

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Crisis Economics

June 29, 2010

Discussing whether the recession is headed for a double-dip, with Nouriel Roubini, Roubini Global Economics chairman.


(Source: CNBC)

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Deflation the Primary Risk Ahead

June 29, 2010

David Rosenberg, Chief Economist for Gluskin Sheff loves fixed income (we do too if you haven’t guessed).  While it might not get as much attention as a ringing endorsement from the likes of “Blue Horseshoe”, that says alot.  Rosenberg sees deflationary pressures ahead, which in turn, should drive long term bond yields even lower and make investments focused on income, “king”. 

Inflationary expectations as indicated by the yield differential between the current 10-Year Treasury and 10-Year Treasury Inflation Protected Securities (TIPS) has declined 50 basis points since the end of April to 1.90 percent.  The Long Bond has tracked a similar path and is now at 4.00 percent.  As stated in Gluskin Sheff”s June 28 daily report, “Breakfast with Dave”, Rosenberg thinks that the decline in yields has some legs to it as the Long Bond could reach levels similar to what we saw in the 1930′s.

Considering that we are heading into a permanent environment of 2-3% nominal GDP growth – along with low real growth and modest deflation – we should expect the long bond to ultimately drift into that range. After all, real final sales is running at a mere 0.8% annual rate as it is, and the leading economic indicators are rolling over. So, how we manage to avoid a double-dip, especially with the Fed and the government bereft of any policy options, is a legitimate question at this juncture; and with underlying inflation at 0.9%, and the risk of a widening output gap as benign economic growth fails to absorb widespread excess capacity. In manufacturing, commercial real estate, housing and labour, it is an equally legitimate question as to whether outright deflation can be avoided at this point.

Based on last week’s post FOMC meeting press release, these seem to be the issues front-and-center on the Fed’s collective mind. If all that happens is that headline inflation converges on core inflation, and that real GDP growth converges on real final sales, then we could well be talking about sub 2% nominal growth. So when we talk about the long bond heading towards a 2-3% range, it is not a stretch to see it ultimately break below that band, as it did in the late 1930s.

Furthermore, he points out that dividend paying stocks and municipal securities should perform in a deflationary environment.

The weekend press was filled with stories of dramatic restraint still coming out of the State and local government sector, and not just to deal with huge budget deficits but also massive unfunded pension liabilities. For one example of how deep the cuts are, see Facing Deficit, Oakland Puts Police Force on Chopping Block (this is happening in one of the country’s most crime-laden cities). And in today’s FT, also have a look at this article on the matter – U.S. State Budget Crises Threaten Social Fabric.

Pressures are building in Washington to start exercising some fiscal prudence too, though there is little sign that the White House is listening. But as we saw last week with the failed attempt to pass yet another extension of jobless benefits, it is Congress that legislates, not the Administration. And there are other pressures building from within – just have a read of U.S. Deficit Proved Key to Orszag Departure on page 3 of the weekend FT.

The trend back to fiscal probity is gaining popularity. We see it in Canada and look what is happening in the U.K. – talk about resolve if the budget austerity measures actually see the light of day (Mr. Osborne considers himself to be a modern-day Maggie Thatcher). The Germans are turning a deaf ear to President Obama’s calls for more stimulus. Japan is set to double its consumption tax rate. The Club Med countries have no choice but to undergo dramatic retrenchment – either that, or face default.

This move towards fiscal restraint has triggered no shortage of complaints from the neo-Keynesians, but the reality is that 80%-plus debt-to-GDP ratios are a real game changer in the industrialized world. You reach a point of diminished returns, and we are likely at that point. And at a time of a sputtering recovery, fiscal belt-tightening will likely intensify global deflation pressures – with the risk that the deflation itself will impede, though not necessarily reverse, the move towards fiscal rectitude.

Nobody ever said deleveraging cycles were painless events. Just read Rogoff and Reinhardt, or the McKinsey report for that matter. Also have a read of a shorter “take” on what is coming down the pike; on page 16 of the weekend FT – Spectre of Deflation is Back to Haunt Investors.

In a deflation environment, income is king. Two articles come to mind from our weekend reading: Dividends Are Back on page B7 of the weekend WSJ and Muni Bonds: Don’t Hit the Panic Button Yet on page B8.

For the dividend theme, after a hiatus in 2009, this strategy has really taken off with the U.S. stock dividend index up 1.9% year-to-date while the overall market is down 2.5%. So far in 2010, the good news is that income-seeking equity investors have seen 136 of the S&P 500 companies raise their payouts, or initiate new programs, while only two have cut or suspended theirs. After a net cut of $37 billion in payouts last year, dividend payments have rebounded $11 billion so far in 2010 (there is more on this theme too on page 5 of the Sunday NYT biz section — Dividends Are Rising: Will Stocks Follow?).

As for the muni article, it contained a lot of useful information dispelling the myth of widespread municipal defaults, notwithstanding the intense fiscal challenges of the day. For example, from 1970 to 2009, the 5-year default rate on municipals has averaged the grand total of 0.03%– compared with 0.97% for corporates. On average, there are have been eight muni insolvencies per year since 1934 – so focus on cash reserves, tax capacity and the refinancing calendar and avoid the risky credits. Muni bonds are not CDOs, subprime mortgages, Greek debt or speculative tech stocks.

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Bond Market Outlook

June 29, 2010

Michael Gallagher from IDEAglobal has the latest from the fixed income market Monday.


(Source: CNBC)

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