BondSquawk

By Maulik Mody – Bondsquawk.com

April 11, 2011

The hawkish outlook of economists is evident in the 10-Yr breakeven rate, which reached a 3-year high of 2.66% at the end of last week and currently trades at 2.65%. The 5-Yr breakeven reached a high of 2.46%, its highest in 3 years.  Treasury breakeven rate is the difference between the yield of Treasuries and TIPS (inflation indexed securities) having similar maturities which shows traders’ expectations of inflation over years to come. The yield of TIPS is said to be real interest rate, as opposed to the return from Treasuries which is nominal rate. The rally in the past ten days in the 10-yr breakeven rate is shown below.

Wide breakevens are a result of increasing oil prices given the unrest in the Middle East. Crude oil crossed $113 at the end of last week before falling slightly to $111.86 this morning. As a result, consumer prices in the US are expected to gain at a faster pace this week. CPI is expected to have gained 0.5% during March, and 0.2% excluding energy and food prices. The retail price index has advanced at a rate of at least 0.4% since December 2010, setting the stage for inflation.

A closer look at the Treasury and TIPS yields over the past ten days shows that inflation expectations widened mainly as Treasuries declined, pushing nominal yields higher. TIPS have been strong the past week but wider breakevens was a result of both, decrease in real rates and increase in nominal rates. Charts for the yield of 10-Yr Treasury and 10-Yr TIPS is attached below, which explains the rise in breakevens.

Given that the economy is hardly out of the woods, the recovery is yet to gain momentum and stocks are exhausted from resistance from the Japan and Middle-East crisis, breakevens are at relatively higher levels. But this gain will be sustained as traders and portfolio managers will are unlikely to sell TIPS unless concerns about the Libyan crisis ease and energy reverses its gains.

April 1, 2011

The March employment report came in above expectations with a 216k increase in nonfarm payrolls after a 194k increase in February. While weather effects that had boosted February faded with construction shedding 1k workers after rebounding 37k in February, other sectors more than made up the difference. Somewhat surprisingly the manufacturing sector saw a loss of momentum adding just 17k people after 32k a month earlier. Meanwhile the private service sector saw hiring surge to 199k from 167k. Sectors of strength included health care (+45k), restaurants and hotels (+35k), temporary workers (+29k) and retail (+18k). Tax season led to the hiring of 20k accountants after losing 5k in February.

The government sector continued to weigh on overall growth shedding 14k workers after a downward-revised 46k loss. The household survey was stronger than the establishment survey for the fourth month in a row showing a 291k gain and leading the unemployment rate to fall to 8.828% from 8.922%. The participation rate was unchanged making March the second month that the unemployment rate declined mainly on job growth rather than a reduction in the labor force. While it is moving in the right direction, the elevated unemployment rate continues to keep wage growth at bay and average hourly earnings were flat leaving the annual growth at 1.7%, roughly where it has been tracking over the prior year.

Aggregate hours worked rose 0.2% and are rising 2.0% at a 3-month annualized pace, about the same as in Q4. The combination of stable growth in hours worked and wages suggests that nominal growth in take home pay remains stable at just below 4% in Q1. Meanwhile headline inflation has accelerated from 2.6% q/q in Q4 to 5.2% in Q1, likely the cause of the recent slowing in real consumer spending growth. Overall the March report provides further evidence of a broad-based hiring dynamic that is capable of generating self-sustaining growth. However there is still considerable slack that is restraining wage growth pointing to a growing conflict between firms and consumers in absorbing rising commodity prices.

In other releases, the ISM manufacturing index remained strong in March, edging down to 61.2 from 61.4. The details were mixed as production picked up to 69.0 from 66.3 and supplier deliveries increased to 63.1 from 59.4 while new orders dropped back to 63.3 from 68.0 and employment moderated to 63.0 from 64.5 (consistent with the moderation in manufacturing hiring in the employment report). Fifteen of eighteen industries in the survey reported growth and the anecdotes continued to be strong with respondents saying “new orders continue at a robust pace” and that there has been some acceleration in orders in anticipation of higher prices in coming months.

Stocks climbed higher on better employment reports and sustained manufacturing activity. The S&P gained 0.8% at 1336 and NASDAQ climbed 0.6% higher to 2798. Treasuries gained slightly as yields inched lower across the curve. The benchmark 10-yr was trading a basis point lower at 3.46%. Oil price gained as WTI crude traded almost 1$ higher at 107.69. The dollar lost ground against other currencies as the DXY index fell 0.7% to 75.801.

March 28, 2011

Personal consumption spending rose 0.7% in February, a little above consensus expectations, while income grew just 0.3%, a little below consensus forecasts. The combination led the personal saving rate to dip to 5.8% from 6.1%, still an elevated pace by historical standards. Most of the increased spending came from higher prices, and real spending expanded 0.3% after a flat reading a month prior. On a 3-month annualized basis consumer spending rose 2.1% through February, about half the pace seen at the end of Q4 as consumers absorb the blow from rising prices.

Wage and salary growth was relatively sluggish in February reflecting the subdued gains in hours worked and average hourly earnings. Taking inflation into account real disposable income actually fell 0.1% in February. Economists expect the March employment report to feature a healthier increase in take home pay although headline inflation will continue to tax away some of those gains. Core consumer prices rose 0.2%, as expected, leading the annual pace to tick up to 0.9% from the record low 0.8% recorded over the past two months. This is still well below the Fed’s comfort zone and so there is plenty of room for the Fed to remain accommodative. On balance the report is a mixed bag of news highlighting that rising prices are taking some steam out of recent momentum, but consumers remain on a moderate track of spending growth and continue to save at elevated rates

By Maulik Mody – Bondsquawk.com

March 22, 2011

High yield bond issuance is reviving this week after falling over 50% for the past two weeks on increased concerns about a nuclear disaster in Japan and growing tensions in the Middle-East.  The amount of new issues sold fell to $2.45 billion in the week ended March 18, just two weeks after markets saw $12.6 billion worth of high yield bond sales.  This week will see Intelsat issuing $2.65 worth of speculative debt in 10-12 years maturity spectrum, among many others.

The high yield debt has out-rallied other safer grade bonds and stocks since the financial crisis, as borrowers continue to take advantage of record-low rates. The BoA Merrill Lynch High Yield Master index shows that high yield markets returned 2.1% and 1.3% in the first two months of 2011 respectively, after over 15% of total returns in 2010. The relative yields (yields in excess of Treasuries) also tightened from 516 basis points last week to 493 yesterday.  The increasingly narrowing spreads and inflow of debt in the market suggests that speculative debt may continue to be a hot investment for months to come.

This raises the question of how to make the most of the fact that once the economic recovery looks stronger and interest rates start rising, there is going to be a major pullback in high yield bonds that will create good trading/investing opportunities. An alternative ETF was released today by ProShares, called The ProShare Short High Yield (SJB), which is designed to provide a daily return which is an inverse of Markit iBoxx Liquid High Yield index’s daily performance.

SJB can prove to be a good way for investor’s to hedge their position in high yield bonds or to bet on their view on the speculative debt market.  But since it was designed to provide -1x times the daily return of the Markit iBoxx index, it will mostly likely need daily rebalancing, which will incur transaction costs and have tax implications. This will not however impede investors from betting against the market and making the most of the rebound, whenever it happens.

March 16, 2011

The producer price index jumped by 1.6% in February, this time driven by both high energy prices and food prices. Energy prices jumped 3.3% after the 1.8% increase in the previous month. Meanwhile, foods surged 3.9% following a surprisingly weak reading in January. The increase in food prices was driven by a 48.7% surge in the price of vegetables.

Core prices (ex food and energy) posted a 0.2% increase. Core pipeline pressures picked up lately with core crude prices and core intermediate prices increasing for the seventh consecutive month. The latest report suggests that producers are passing along some of their higher input costs. The prices of certain components of core PPI such as textiles, which are directly affected by surging commodity prices, continued to increase rapidly. Men’s apparel jumped 2.3% m/m following a 0.5% increase in the month prior. Core PPI is best correlated with the core goods component in CPI. Core goods have been on a constant downward trend as of late, but there is a limit to how much further it could fall. A 0.2% increase in Core Goods CPI was seen and economists expect the reading to get firmer.

Housing starts unexpectedly fell by 22.5% in February, its biggest decline on a monthly basis in over 25 years, after rising 18.5% in January. Housing starts fell from 618k in January to 479K (annualized) in February, its lowest level since April 2009, as both single family and multi-family starts slowed. Housing permits continued to fall for a second month, declining 8.2% in February m/m.  Mortgage applications as seen in the Mortgage Banker’s Association index fell by 0.7% last week even as borrowing costs declined. The average 30-yr FRM rate fell to 4.79%, the lowest in two months, but relatively high unemployment and expectations of housing prices falling further refrain Americans from buying new houses.

Stocks fell and Treasuries extended gains amidst concerns over the after effects of Japan’s earthquake on its nuclear power plants. Treasury yields fell across the curve on increased demand for the safe haven securities. The benchmark 10-yr note traded 7 bp lower at 3.23%. The 2-yr yield fell 3 bp to 0.60%. The S&P shed 0.8% and was last seen at 1270.84 as of 11:39 AM EST. DJIA and NASDAQ were both trading a percentage point lower.

By Maulik Mody – Bondsquawk.com

March 10, 2011

U.S. government bonds gained after report today showed that the U.S. trade deficit widened in January by almost $6 billion to $46.3B. Economists had expected it to widen by roughly a billion dollars to $41.5 billion. This widening of the deficit was caused mainly as imports increased by 5.2% m/m as opposed to exports, which grew 2.7%.  The total export ex-petroleum increased by $4.8B to $19.67B.

Export of goods increased to $120B but a higher increase in imports caused the goods deficit to increase by $6B to $59.7B. The surplus in services was unchanged due to small similar increase service imports and exports.

The increase in exports of goods was due to increase in industrial supplies (10.2% m/m) and automotive vehicles and parts (13.4%). Imports considerably increased mainly in capital goods (5.3% m/m) and consumer goods (2.2% m/m).

 Among trading partners, the nominal trade balance with China deteriorated on increased imports and decreased exports. Trade balance also reduced with OPEC nations and African nations on increased imports. If the unrest in North Africa does not subside by this month, this can worsen in the coming months due to increased oil prices.

The Labor Department reported that initial jobless claims in the week ended March 5 climbed 26,000 to 397K after 371K in the previous week. Although claims came in higher than expected, it is the third consecutive reading below 400K and the second time the 4-week moving average is below 400K. The Labor Department has said earlier that “it takes a sustained improvement below 400k to have any appreciable effect on unemployment,” and this can certainly be regarded as an encouraging step towards today’s recovery.

Treasuries increased in price and stocks fell in this morning. The benchmark 10-Yr note traded 2 bp lower at 3.45%. The Long Bond was also 2 bp lower at 4.59%. The S&P retreated 1.3% to 1303.43. Oil prices also fell on concerns that slowing global recovery will reduce demand for oil. Crude price fell by around $2.8 and its April future contract was trading at 101.80.

By Maulik Mody – Bondsquawk.com

March 9, 2011

Some investors may not know where the yield of a bond is headed, or what the price appreciation will be for a particular bond if rates fall, but they have a general view about the creditworthiness of the lenders and may want to trade based on where they think spreads are headed over time. Trading a CDS for a given issue is one way of trading the corporate credit of a company.

A Credit Default Swap (CDS) is essentially an insurance that promises the holder of a corporate (or other) bond the value the face value of the bond, less the value of the defaulted debts, in the event that the issuer defaults. In return, the CDS holder pays a percentage (called spread) of the insured amount to the protection seller every year till the bond expires or defaults. These spreads move up and down with a change in the perception of the creditworthiness of the issuer among other things, hence creating trading opportunities.

Trading in CDS however is done over the counter and is not a very liquid market. This also increases transaction costs due to wide bid-offer spreads. Another way of trading corporate credit is to trade credit default swap index (CDX), which allow investors to speculate on the creditworthiness of a basket of entities or the hedge the credit risk of a portfolio. As opposed to a CDS, a CDX is a more standardized credit security hence more liquid with tighter bid-offer spreads. Just like a CDS, the spread of a CDX typically rises when investor confidence in corporate credit falls and vice-versa. An example of an a CDX for high grade bonds is the Markit CDX North American Investment Grade Index (CDX.NA.IG), which constitutes of 125 equally weighted securities from various sectors such as Financials, energy, utilities, industrial, consume cyclical etc.

So what’s making these indices move so much in the current environment?  Many different securities have been affected by the middle-east crisis and swaying oil prices, and CDX is no exception. Concerns about rising crude prices and the effects that a decrease in oil supply can have for countries and companies is causing the spreads to widen. But more interesting is the fact that these CDX spreads are moving in tandem with oil prices. Bloomberg reported last week that the correlation between the CDX and crude futures rose to 0.7, the highest so far. Correlations vary from -1 to 1 where negative 1 means that they move exactly opposite with the same magnitude, and a positive 1 indicates the two move in lockstep.

For the credit trader, this gives a good opportunity to trade CDX using the dynamics of crude futures, and for the investor, it may be a chance to bet on the general longer term trend of credit. In either case, one can expect spreads to come down to normal levels after the Middle-East unrest is over. History is evidence that oil has, on numerous occasions, settled near its pre-crisis trading levels after any crisis that has threatened the supply of oil has subsided.

March 4, 2011

The February employment report came in a little stronger than expected with nonfarm payrolls increasing 192k, in line with expectations, while the unemployment rate fell to 8.9% from 9.0% as the participation rate was unchanged. There was also a 58k upward revision to past estimates. Private sector hiring was stronger than expected with a 222k gain while the government sector let go 30k workers at the state and local level. There was some pay back from weather-related weakness in January as the construction sector added 33k after a 22k drop, while manufacturing added a robust 33k jobs after a 53k increase in January. Private service sector hiring improved to 152k from 33k and it was not reliant on temporary hiring which improved to just 16 k after a 5k drop a month prior.

Within the details professional and business services added a robust 47k while health care contributed 36k. Leisure and hospitality also added 21k after a weather-related decline of 3k in January. Overall the 3-month average for total nonfarm payrolls stands at 136k, above the roughly 110k needed to hold the unemployment rate steady. Importantly the private sector is carrying the day averaging 152k over the past three months, enough to offset the headwind from state and local governments.

Importantly for Fed policy, wage growth was flat in February after a surprisingly strong 0.4% increase leading the annual pace to return to its recent lows of 1.7% from 1.9% last month. While the unemployment rate is moving in the right direction on an apparently sustained basis, it is still elevated and downward pressure on wages remains.

Chairman Bernanke noted in his testimony before Congress last week that they will be looking at wage growth as an indicator for how much firms will be able to pass through commodity inflation into core prices. The lack of re-entrants into the labor market was also a surprise and suggests both a structural downward trend in participation owing to the retiring baby boomers and a lack of opportunity for others who have given up looking for work. The report also showed a gain of just 0.2% in aggregate hours worked as average weekly hours remained at a relatively subdued 34.2. Thus the report suggests that wage and salary growth will be solid in Q1, but probably will lag behind headline inflation. Overall the report confirms an improving trend in the labor market which will serve as an important foundation as firms and households grapple with rising food and energy prices in the months ahead.

Stocks declined this morning as investors feared that the sluggish growth in wages may fail to keep up with the rising oil prices, which will affect the cost of other commodities. Treasuries rallied across the curve, with yield at least 5 bp lower across the front end of the curve. The yield on the benchmark 10Y-y note was 5 bp lower at 3.51%. Oil continued to rise, with the April contract trading at 103.54 this morning.

March 3, 2011

Initial jobless claims dropped 20k in the week ending February 26 to 368k, the lowest level since May 2008. This was the President’s Day holiday shortened week, however, the Labor Department analyst said that there was “nothing unusual” in the data. This was the second consecutive reading below 400k, and the first time the 4-week moving average dropped below 400k reaching 389k. Recall, the Labor Department considers that “it takes a sustained improvement below 400k to have any appreciable effect on unemployment,” however, today’s reading is certainly another encouraging step for the labor market recovery.

Mr Trichet gave his most explicit signal ever that rates will rise, in April. While he said this was not the start of a series, he said that at the beginning of the last series. We expect the second rate hike in June, and no later than July.

The ECB surprised by extending the availability of 3-month fixed rate repos until June, emphasising the split between monetary policy and stability-oriented measures.

The ECB stance will stiffen expectations for a hike soon in the UK. However, consumer confidence is down sharply and weak underlying Q1 GDP would worry the Bank of England a lot given the fiscal tightening still to come.

Tensions in MENA may yet spread and disrupt oil supplies more seriously, which could have profound effects on growth and inflation. For now, however, the effect on growth might be no more than 0.5pp in the US and eurozone.

Stocks rallied higher and Treasuries fell today after the Labor Department reported that the number of people filing for unemployment declined and the service industry grew at the fastest rate in 5 years. Crude oil fell from its highest level in a year, and Gold prices also bounced off its ceiling.

By Maulik Mody – Bondsquawk.com

March 2, 2011

Stocks inched up higher and Treasuries eased after employment reports showed increased hiring in the private sector and the Fed said in its beige book that labor market is improving. Unrest in the Middle East continued to push oil prices higher. The dollar fell against other currencies while Gold climbed to an all time high.

Economic Data

The ADP employment report showed a pick-up in private sector hiring to 217k in February from an upwardly revised 189k in January. Economists had expected an increase of 180k last month. The ADP has over-predicted private payrolls by 122k over the past two months before which they under-predicted by an average 56k over the preceding six months. Hence economists at BNP Paribas expect private payrolls to have increased by 185k during February.

The Mortgage Bankers Association showed that mortgage activity in the US decreased by 6.5% for the week ended Feb 25, as both purchases and refinancing fell over 6%. The 30-year fixed mortgage rate fell 16 bp to 4.84%.

The latest Beige book reported released by the Atlanta Fed indicated that the economy is improving at a moderate pace and the labor market is stabilizing. The report covers the period from 4 January through 18 February, when high-frequency economic data were indicating improvement, especially in the manufacturing sector, while the housing market remained depressed. The Beige Book indicated that almost all districts “experienced solid growth in manufacturing production.” While “construction remained at low levels across all Districts,” retail sales increased, tourism improved and “labor market conditions continued to strengthen modestly.”

Interest Rates

Treasuries fell as yields gained across the curve on reduced demand for fixed income products after economic releases today suggested that the labor market was improving in a steadily improving economy.

The yield curve steepened, as rates in the longer end of the curve rose more than in the front end. The 2-Yr fell as its yield pushed 8 bp higher to 0.69%. The belly of the curve steepened as the yield on the 5-Yr rallied 7 bp to 2.17%. The benchmark 10-yr note fell pushing its yield 8 bp higher to 3.47%. The Long Bond also fell as its yield gained more than 8 bp to 4.56%.

Inflation expectations, as seen by the yield differential between the 10-yr Treasury and 10-yr inflation indexed bonds (TIPS), increased 5 bp to 2.47%, its highest level in a year.

Across the Capital Markets

Stocks ended slightly higher on improved economic outlook. The S&P climbed 0.2% to 1308.44, while NASDAQ gained 0.4% to 2784.07. The VIX Volatility index fell 1.5% to 20.70.

The DXY index, which measures the dollar against six major currencies, fell 0.6% to 76.651. Euro gained 0.7% against the dollar to 1.3866. The cable (GBP/USD) gained 0.3% to 1.6325, its highest level in a year.

Crude oil pushed higher amidst unrest in Libya and ended the day at 102.40 a barrel. Gold pushed to an all-time high of 1434.50.