Commentaries

Now you can get inflation protection for the (super) long haul

Treasury announced that it’s tweaking its TIPs program so investors can get inflation protection for 30 years rather than 20 years. It will certainly make break-even calculations much easier since the government doesn’t sell regular run-of-the-mill Treasurys with 20-year maturities.

The first batch of 30-year TIPS will be sold in February, while the 20-year variety will be discontinued immediately.

Oh, where has all the convexity gone?

The rise in U.S. Treasury yields has been very impressive considering where stocks are – the Dow is just 80 points away from 10,000 – and the improvement in economic data.  But it’s even more incredible that it happened without the aid of investors in mortgage-backed securities and mortgage servicers that typically snap up longer-dated debt like U.S. Treasuries and swaps to hedge their portfolios when interest rates fall sharply. It’s known as convexity hedging, and it was a powerful accelerator in the U.S. Treasuries market in 2002 when the Federal Reserve was pushing rates down. (It also works the other way. When rates rise suddenly, it forces mortgage investors to quickly start selling longer-dated debt.)

Deutsche Bank in a recent note says it’s been largely absent this go around, largely due to government intervention. This is important because the Fed’s exit from the agency mortgage market also means this $4.5 trillion market is likely to re-assert its influence over benchmark Treasuries. If yields are rising by then, such MBS freedom could accelerate the move. And that has an impact on mortgage rates and any other debt using Treasuries as a benchmark.

Here are DB’s reasons:

1) The Federal Reserve is the dominant force in the market. It owns 23% of the outstanding 30-yr agency market, and guess what, it doesn’t need to hedge.

2) It’s impossible to tell how much investors should be hedging since the Fed’s intervention has skewed prices too much to figure out how much risk is out there.

3) Estimates of convexity and duration risk (which is determined by when you think borrowers will refinance their mortgages) have become increasingly difficult to pinpoint since the government’s Home Affordable Refinance Program hasn’t caused a spike in prepayments yet. So those that would typically hedge are likely hunkering down.

4) Technical reasons that involve short-dated and long-dated volatilities, which I’ll leave to the experts to explain:

Not looking hot on the jobs front

Data just out shows the pace of joblessness picked up in September, snapping what had been a steady improvement from “really terrible” to “at least it’s not as terrible as the prior month.” The drop in non-farm payrolls was even worse than Goldman Sach’s downwardly revised -250K forecast, coming in at -263K. But also take a look at July: revised to -304 from -276k. August was revised to -201K from -216K.

The unemployment rate ticked up an expected 0.1 ppt to 9.8%.

Also average hours worked in a week slipped further to 33.0 from 33.1. I guess employers are cutting hours as well as jobs. Not exactly confidence inspiring for the nation’s shoppers.

This is not good news for those hoping for a consumer-led recovery. Sure inventory rebuilding will give GDP a nice pop over the next two quarters, but then what? And inflation? Not likely any time soon with numbers like these.

You can find the full report here.

Treasury market seems to be thinking along the same lines, as yield on the 10-Yr note falls even more to 3.12%. Dollar also getting hit.

A compelling case for carry in Treasuries

Under normal circumstances, U.S. Treasuries should probably be getting clobbered.

The worst of the credit crisis is over, the economy is expected to snap back in the second half of the year, and the appetite for riskier, higher-yielding assets should be siphoning off demand from boring, safe-haven assets like Treasuries.

But things haven’t been normal for a while.

Treasury yields are down substantially from three months ago. This week provided additional evidence that something is not quite right. The government dumped $70 billion of three-year, 10-year and 30-year Treasuries into the market, yet yields fell.

But when you consider how much banks and other investors who enjoy dabbling in leverage can make by deploying that oldie, yet goodie, “the carry trade,” the recent rally in Treasuries doesn’t seem so crazy.

The carry trade in its simplest form is a way for investors to make money by borrowing at short-term low rates and investing in securities that yield much more.

Right now, short-term funding costs are at rock bottom rates — the overnight federal funds rate is sitting around 0.15 percentage point and three-month London interbank offered rate at just 0.3 percentage point. The 10-year benchmark Treasury note yields 3.33 percent and the 30-year bond, 4.16 percent.

Too much Treasury supply to bear?

Treasury’s auction of $20 billion of 10-year notes – the second in a three-part $70 billion fund raising effort this week – drew in some aggressive bidding, but the broader market is having problems finding its footing in the aftermath.

The long bond had piled on more than 6BPs in the immediate aftermath of the sale Tuesday, though it’s pulled back some in the interium, making for an attractively steep yield curve for those funding their longer term purchases at short term rates. The spread between 3-month Libor and the long bond now stands around 407 basis points.

This brings up another point. Yesterday, the blog zerohedge posted a piece from its guest blogger, Yves Lamoureux of Blackmont Capital, who noted some unusual behavior in the bond market- namely that dealers are holding onto their long positions in 30-year Treasurys. You can see the full post here.

But given the steepness of the yield curve, I wonder why they would significantly want to pare them down. It’s one of the easiest ways to generate gains and with the Federal Reserve not even hinting at a rate hike, it’s a trade they’re likely to keep on for some time.

Job declines slow, but unemployment rate jumps

The Labor Department’s August report on the jobs market has a bit of a good news/bad news slant to it. Job cuts slowed to “just” 216K, below expectations and better than last month’s 276K (up from the originally reproted 247K). But the unemployment rate, which is calculated through a distinct survey of households rather than businesses, jumped to 9.7% from 9.4% the previous month. You’ll remember that a slide back in July made some hopeful that maybe, just maybe, joblessness has stabilized.

Still, the market doesn’t seem to be too worried, at least for the moment as Treasury yields head north. The benchmark 10-Yr note has inched up about 2BPs to 3.39% since the report hit the wires.

The take away, however, continues to be that job losses are still outsized and likely will keep consumption and housing from recovering in a meaningful way.

That didn’t take long…

Turn the calendar to September and markets are fixated about potential problems at the banks again. The obsession with September being a bad month for stocks and for the world in general has nothing to do with it, I’m sure.

I’m certainly the last person to downplay the still tough road ahead given the state of the U.S. consumer, commercial real estate and the excesses that still need to be wrung out of the system, but the fickle trading, especially in the stock market this summer, has made it difficult to read too much into the daily moves.

But the worry does look real, at least for today, given the flows.

The DJIA and S&P 500 are down around 2% and the S&P dipped back below 1,000. Meanwhile, funds are being redirected into shorter-dated Treasuries with 2-Yr through 7-Yr yields down around 5.5BPs to 6.8BPs. The flattening of the year curve is telling you this has to do with fear, not a reach for yield (especially when the 2-Yr note is trading below 1% now.)

That this is happening on a day of solid economic data – the ISM manufacturing report not only came in much better than expected but it indicated expansion for the first time since Jan. 2008 – makes the behavior more noteworthy, even if it is coming during the last week of U.S. summer.

Treasury yields not adding up

What is going on with U.S. Treasury yields? Can nothing nudge them from their current low-laying perch? Something seems very out of whack, but let’s just agree not to call it a conundrum.

There’s plenty out there that should be ratcheting up interest rates. The U.S. stock market has been on fire, with the S&P 500 still hovering near its best levels since October, the White House is projecting $9 trillion in debt over the next 10 years,  the economy is showing signs of improvement (a bond very unfriendly development), and a flood of new debt is already washing over the U.S. Treasury market

In fact, the U.S. Treasury sold $42 billion of newly minted two-year notes on Tuesday with little trouble and will dump another $39 billion of five-year notes later today. And this after a record quarterly refunding, $75 billion big ones, hit the market just two weeks ago. Just how much supply does it take to convince investors to start charging higher interest rates?

The chart below shows the trajectory of the 10-year Treasury yield. The most recent peak of 3.85% was Aug. 7, before the refunding and before the Fed’s announcement on its Treasury purchase program winding down.  It’s about 40BPs lower now.

Compare this with the S&P 500. It closed at 1010 that day. It’s currently trading at 1031.

Fed MBS tally jumps to $766.6 billion

The Fed may be paring back its Treasury purchases, but its MBS program heated up this week. The central bank bought a cool $25 billion net, up nearly $5 billion from the previous week. Reuters puts the running tally now at $766.608 billion.

Treasurys not looking so boring anymore

Government securities are not the most exciting investment choices in the best of times, but it looks like U.S. Treasurys are coming into their own, which is good news for the federal government and its financing costs.

Though it may feel like Wall Street has returned to business as usual, it looks like banks, like U.S. households, are building up their Treasury piles now that they’ve had their fill of more exotic investments.

The Wall Street Journal’s Andrew Baston has the figures here on how U.S. buyers now rival China when it comes to their importance in financing the U.S. deficit. RBS adds banks to the mix and has a nice good chart to illustrate it.

Check them out them out here.

Here’s the chart on household holdings.