The Interest Rate Report

Europe Back in the Spotlight. Focus on Italian Banks.

Mike Marshall — 2011-07-12T14:54:00Z

Mike Marshall

Interest Rate Analyst

1-800-216-1485

mmarshall@pfgbest.com

As I surmised the other day, the Italian banking sector has been moving to, and is now at, the forefront of European concerns. Yeasterday’s headlines included two Italian banks: INTESA SANPAOLO and UNICREDIT both subject to halted trading after moving to limit down. Upon re-open, prices continued to fall. The Euro/Swiss pair has also fallen aggressively on the news, which is also weighing heavily on US stocks and bidding up bond prices.

Essentially, we are looking at another risk off style trade, where markets like the US Treasuries are expected to see safe haven investments and should strengthen from here. That is of course assuming that the market will not take this recent break in the equities as a chance to buy the dip. Nonetheless, it does not look to be smooth sailing for the Europeans this week, as the EURO has fallen below, yet recovered, through the 1.40 level today.

Weakness in the Euro currency appears to be bringing about buying of the US Dollar, and USD strength is in turn helping the US bond markets. With the imminent Aug 2 debt ceiling deadline fast approaching it is imperative that Congress reach a concession on debt talks so that the US will be able to continue issuing debt. Fortunately, the markets do not seem to be terribly concerned over this issue, as the more pressing dangers of the Euro zone continue to take the lead.

Though there may be some brief respites from Euro zone pressure, their problems are truly just beginning in earnest. As much as I would like to be a seller of US bonds at the current low rates, a deflationary swing may be brewing in the US. As long as the Dollar remains the world’s reserve currency, concerns overseas should allow the USD to strengthen taking bond prices with it. Anyone thinking that the Chinese will step in to help the Europeans should think again. China, potentially in the early stages of an inflationary credit crisis, was unable to sell all of its 3yr debt at a recent auction, only placing 23.9B Yuan instead of the intended 25B at a yield of 3.93%. This appears to be due to the much higher yielding 7 week paper which returns near 7% for significantly less duration. Only making matters worse is the drying up of the secondary market which means the banks required to buy Chinese notes at auction must hold them to maturity as there are few buyers to which they can then sell to.

As long as pressures on foreign countries remain, it is likely that the US Dollar will be the prime beneficiary along with US bonds and notes. Sadly, this cannot be said for US stocks, though continued low rates in the US may be a godsend for any potential domestic recovery. For now, all eyes should remain on Italy and Spain, with a wary focus on the US debt ceiling talks.

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ECB Surprise and ADP

Mike Marshall — 2011-07-07T14:54:00Z

Mike Marshall

Account Executive

1-800-216-1485

mmarshall@pfgbest.com

This morning stocks are trading firmer and bonds weaker after a better than expected ADP jobs report. Assisting the strong stock market is also the surprise announcement from the ECB that it will temporarily lower the ratings threshold on Portuguese paper.

After the Moody’s ratings agency downgraded Portuguese debt to junk status a few days ago, essentially knocking the Portuguese out of the capital markets, the ECB has announced that it will now accept any and all worthless paper from the Portuguese central bank as collateral for new loans. This sets a very dangerous precedent for the ECB as any other countries feeling the pinch will begin unloading their toxic junk right into the ECB coffers.

The real oddity to me, is the market reaction, which seems to have sent the Euro soaring higher by a full cent this morning when in fact this move points to the conclusion that the ECB will be forced to print large amounts of fresh Euros to swallow enough junk for the Portuguese to continue issuing debt. Coming so shortly after the Greek debt talks, which appear to have stalled once again, this move should relay just how much trouble Europe is in. Perhaps a well timed currency intervention by the ECB and/or PBOC has come into play to support the weakening Euro, but that has yet to be disclosed. On the other hand, the bailout talks are just beginning, and despite the long term negative effects of a move like this, the short term reaction is one of bullishness as it signals that the ECB is prepared to do what it takes to support its ailing economies. As long as the Euro remains strong, the US Dollar should remain weak, and thus drag down the value of US bonds which have also fallen on this latest news driven event. Traders should be on the watch for an unwind of this trade, and potentially a short term buying opportunity in the bond and note futures though as of the writing of this report, no signs of equity weakness have presented themselves as would be needed for a long bond setup.

QE2 and POMOs now over. Bonds Celebrate with Selloff.

Mike Marshall — 2011-07-01T14:54:00Z

Mike Marshall
Account Executive
1-800-216-1485
mmarshall@pfgbest.com

This week has been an interesting one for the bond markets. Today marks the official end of QE2 along with the POMO bond purchases. The question of who exactly will be buying US Treasuries now that the Primary Dealers can no longer flip them back to the FED may have been answered: no one. At the very least it won’t be the Chinese who have been busy helping the Europeans mask the beginnings of a liquidity crisis. To give you an idea of how little even the Primary Dealers want to hang on to their recently purchased Treasuries, today’s POMO total of $4.909B consisted almost entirely of 7yr notes auctioned off yesterday. Yes, in less than 24 hours, the Primary Dealers sold $4.405B of the 7yrs right back to the New York Fed.
On the whole, this week’s note auctions have been undersubscribed, with big draw downs in foreign bidding. This led the Primary Dealers to take the majority of issued notes into their coffers as has been the recent trend for weeks. In theory, these firms could be hedging their open market exposure with short futures positions and the recent break in the price of bonds would support this idea. Main stream media would have you believe that fall in bond prices is coming on the back of stronger economic data, as the rise in yields is priced in for a the recovering economy. That might be the case, but my take is that the markets are far more nervous about the lack of FED bond purchases going forward along with reduced foreign interest in US Dollar denominated assets.
For the past few weeks, the markets have focused intensely on the Greek situation. This morning’s passage of the Greek budget bill seems to have eased concerns and led to another round of Euro buying. Aiding this move is the Chinese buying that has been present in the European currency and bond markets as of late. Michael Woolfolk, of BNY Mellon, estimates that the Chinese have been selling $2B in USD per trading session with about a third of that being converted to Euros. This serves both China and Europe as the Chinese are able to diversify their estimated $3Trillion in foreign currency reserves while providing much needed support to the European banking sector which just saw the EUR LIBOR rates double to 1.78% overnight. Much of this has allowed the EUR/USD to remain strong despite obvious weaknesses in the system. The US Dollar has begun to fall again, taking the bond market with it. Moreover, the stalled talks on the US debt ceiling would certainly not be helping the situation though many still believe that a debt ceiling hike will occur right before the Aug 2 buzzer as it has more than 70 times since the 1960s.
For the time being, it looks like the only thing that will come in to save the bond market is a falling stock market. Since the equities are soaring on the news of the Greek budget agreement, Europe’s woes will likely continue to be the main driver for the foreseeable future. Rumor has it that Italy is the next sovereign to watch for signs of pain, and I suspect the European credit crisis is far from over. That being said, I have strong doubts as to whether their concerns will lead them to the safety of the US Treasury market at the still relatively low rates when the Chinese have been willing to assist.

Weak 2yr Note Auction pressure Bonds Lower while European Debt Woes Loom

Mike Marshall — 2011-06-27T14:54:00Z

Mike Marshall

Account Executive

1-800-216-1485

mmarshall@pfgbest.com

Today’s 2yr Note auction, brought showed a large drop in foreign bidding, once again forcing the Primary Dealers to step to grab a whopping 64% of the auction. The biggest cause for concern here is that with QE2 nearing a close, there are no POMO buybacks scheduled for the 2yr duration. Rumor has is that the next round of easing may come in the form of an interest rate cap of the 2yr notes, according to PIMCO’s Bill Gross, but any mention of such a plan has yet to be disclosed. The weaker bid to cover of 3.04 today was not the worst on record, but certainly marks a decline from last May’s BTC of 3.46. Perhaps the most notable factor was the Indirect Bidder take down of a measly 22%.

Meanwhile markets, as a whole, have tended to keep a tight focus on the Greek situation. Though the beginnings of a plan have been announced, sending markets rebounding higher, the Greek bailout must now pass a parliamentary vote scheduled for June 28. Now that the Greek situation is showing the inklings of improvement, it appears as if traders are positioning themselves weakness in some of the less priced in sovereigns. Rumor has it that Italy is the next domino to fall, and should contagion fear increase, I suspect US Bonds may benefit, not only from safe haven buying, but a weakening Euro pushing up the value of the US Dollar, and thus also the stability of US Debt. For now, all eyes should remain on Europe with a specific focus on Italian and, perhaps as well, Spanish banks as further weakness would come at a very inopportune time for the ailing European economy.

Greek Bailout Woes Weigh on Stocks, Bonds, et al…

Mike Marshall — 2011-06-17T14:54:00Z

Mike Marshall

Account Executive

1-800-216-1485

mmarshall@pfgbest.com

Treasuries continue to trade as if linked to outside markets. Much of the movement from the Bond market has come from the back of movements in the equity markets, and since most of the equity movements this week have followed the movements of the Euro, in a sense the bond trade appears to be hostage to the day to day back and forth stemming from an unclear picture on what exactly will happen with the Greek bailout.

Some have argued that the Greek problems are isolated to the tiny country, yet if that were the case, Moody’s would not have downgraded ratings on 3 major French banks citing exposure to Greek Debts. Moreover, the Greek problem, should it persist, has the potential to cause a credit crisis far worse than what was seen after the collapse of Lehman. For those who do not remember, the collapse of Lehman Brothers, which was a relatively minor occurrence in and of itself, led to the almost fatal freeze in the credit markets. Though most people gauge economic health off the price of the stock market, it is really the credit markets that matter most. A freeze in the European credit markets would certainly have adverse effects in the US credit markets and could potentially lead to another deflationary spiral. Without readily available short term credit, businesses, schools, and governments could face a far more difficult time funding day to day activities. An extended credit freeze could halt the entire financial system in a few short weeks.

To be fair, the IMF an EU leaders recognize this reality, and despite Greek protests against austerity, look to be packaging a deal that will allow Greece to continue kicking it’s problems a few months down the road. The deal, as it stands, is by no means a fix to any of the long standing problems of solvency, simply a way to delay the inevitable default. Which is exactly what is needed at the moment. Yet until a long term plan is agreed upon, that will actually address Greece’s funding issues, the picture will remain the same and the risk trade will be off. This means flight to quality assets like treasuries will likely remain in an uptrend and stocks will likely be weighed down by overseas pressures.

FED Steps in for the Late Day Save

Mike Marshall — 2011-06-10T14:54:00Z

Mike Marshall

Account Executive

1-800-216-1485

mmarshall@pfgbest.com

Just as it looked like the stocks were about to tumble to new lows, the FED stepped in with a surprise announcement that the capital charge buffer by Basel may be reduced from the already low 3% to 2-2.5%. For those unclear as to what this really means, it is in reference to the move to bring some $200 Trillion notional in OTC (over the counter) derivatives products onto exchanges. The ensuing scramble for capital at the big banks may well have contributed to some of the downward pressure exerted in the stocks recently. Today’s announcement by the FED to reduce the capital needed clearly found the friendly ear of the stock traders who rushed cover existing shorts, sending the Sep ES contract up 10 points in a matter of minutes. This was the perfect time for a surprise move of this sort out of the FED, as it looked as if this week would finish on a direly negative tone. Once again I am reminded of the need for a surprise QE3 announcement if the same results are desired.

Perhaps I am getting jaded after watching these markets for the past few years, but it seems that just when things look the worst, the powers that be step in with a curve ball. Phil Flynn, our Energy analyst here, loves to sing the adjusted lyrics to the old Sunny Curtis song, “I fought the law” only Phil’s lyrics are, “I fought the FED and the FED won.” If there is one thing I have learned is to never underestimate the lengths to which the FED is willing to go to maintain the illusion of a strong economy. Today’s surprise announcement is a perfect example of this in action. The announcement did not actually state that the capital buffer would be reduced, but that it might be. Apparently, that was enough to turn the market around.

Much like in the case for QE3, the many denials of further stimulus could well have led the stocks lower in recent trading, yet if they fall too far, don’t be surprised to see an announcement for QE3 just when things look the most dire. The “dual mandate” of the FED gives them the leeway to enact such policies as they have now given themselves the duty of creating price stability. For those who can’t read FED-SPEAK, this means a rising stock market.

Bond markets headed lower on the surprise today as the risk on risk off trade seems to have switched to risk on with the announcement. Of course, this is simply one day’s action. If the stocks see a continuation higher on Monday, it may be time to look for long term shorts in the bonds. I suspect, however, that this is not the case though the answer is only evident in hindsight.

In other bond news, the New York Fed has released the final round of POMO purchases for QE2. The full schedule can been seen here at the New York Fed website.

On QE3, NFP, the Debt Ceiling, and the Greek Bailout

Mike Marshall — 2011-06-03T14:54:00Z

Mike Marshall

Account Executive

1-800-216-1485

mmarshall@pfgbest.com

Looking around the markets today has brought about much confusion and very disjointed trade. The number of rumors then denials of the Greek bailout this week alone have made for an absurd trade as investors rush in and out of stock and bonds every time a new statement is put forth. To be fair, Friday’s market reaction to the Greek bailout agreement was much more muted as it appears that traders were simply fed up with listening to denials and firmly believe that a Greek bailout will occur. Why wouldn’t it at this point. The Greek debt situation poses such a systemic risk to the financial system in Europe that a lack of a bailout could trigger a credit freeze much like Lehman did when the FED and Treasury allowed them to fail. Moreover, other European nations still have considerable exposure to Greek debt, and if Greece cannot pay their sovereign lenders, those nations could face a credit crisis of their own. This may seem far removed from us here in America, but if one recalls the events of the 2008-2009 period, it was the surprise fall of the European currency that brought about deflation in the US as the Dollar rallied significantly while the Euro declined.

Contrary what some may think, a strong dollar is not good for the current US economy. True, as the Dollar rises, so should the price of US Treasuries, sending yields lower. Lower yields may allow the Treasury to continue financing is enormous debt load by borrowing more at low yields, yet a significantly stronger Dollar would mean that same debt is paid off in currency at a higher value. Essentially, the Treasury has backed itself into a very tight range of sustainability. In an ideal world, the Dollar would remain weak but not too weak, while the demand for US bonds and Notes stays strong. Yet we do not live in an ideal world, and in fact the US Treasury faces potential default if the debt ceiling is not increased. Absent the currently employed extreme measures of Treasury Secretary Geithner, the US would already have defaulted. Fortunately, he is raiding government pension funds in order to keep up the charade.

I would argue that this week’s price action in the stocks and bonds in indicative of traders pricing in the inevitable and perhaps imminent third round of quantitative easing(QE3). This brings about the topic of the June 3 Unemployment and Non Farm Payrolls numbers. I am hesitant to do so, but the current environment requires us to use a bit of market psychology. The jobs data was poor to say the least. As were the ISM number from earlier in the week. While QE3 is still unpopular on main street, wall street has once again extended their hand in expectation. Poor economic numbers as well as a poor reaction from the stock market could potentially pave the way for QE3 to become an acceptable solution. The poor August 2010 NFP report triggered the chain of events that led the US to QE2, which is set to wind down at the end of June this year. The recent miss on the current NFP numbers could very well set a similar tone.

I believe the question of QE3 will be the most important news for the markets going forward. The Greek bailout has been a foregone conclusion for a while now, and to be fair, the markets have hardly reacted at all to the current Congressional impasse on the debt ceiling hike. As of the writing of the this report, the stocks stand firm off the session lows despite very poor economic data and the Euro is the strongest on the board while bonds have moved down to flat on the day. To me, this non-reaction shown in the markets is due to the expectation of further stimulus in the stocks and bonds. To avoid a US default, and potentially the collapse of the entire financial system, the US debt ceiling will be have to be raised. Much like the case for QE3. I highly doubt the FED will be able to keep rates low without continued stimulus in the bond markets. Should QE3 not be implemented, I suspect that interest rates will start to creep higher, putting further pressure on the Treasury as it struggles to finance its large debt load.

2yr, 5yr Out of the Way. 7yr Remains

Mike Marshall — 2011-05-26T14:54:00Z

Mike Marshall

Account Executive

1-800-216-1485

mmarshall@pfgbest.com

This week’s auctions for both 2yr and 5yr denominations have been well bid. As I have said frequently in the past, the short end has been quite well bid by the Primary Dealers, though yesterday’s 5yr auction internals showed strong bidding from both the PDs and the Indirect Bidders where foreign central banks register. Bid to cover rose to 3.20 while hit ratios fell due to increases in tendered amounts.

Bond markets reacted favorably to the strong auction and rallied to the sessions higher on the results. Today’s 7yr auction may show a similar picture. As of this morning’s missed in GDP and Unemployment Claims, bonds and notes do stand firmer on the day and barring a bid in the equity markets, are expected to remain so. The short end has made new highs for the year while the longer dated notes and bonds appear to be lagging. Perhaps this is a hint that the bond market is prepping for a rollover to the downside though I would argue that this trend should continue as long as inflation fears prevail. The logic behind this is as follows: in a flight to safety, bonds and notes will tend to rally as investors seek the safety of government guaranteed investments. Yet the longer dated treasuries will continue to price in more inflationary fears and relatively higher rates than the short term simply due to the fact that a longer lock up period for ones money leads to less certainty of inflationary pressures.

This morning’s economic misses may well keep the equity markets under pressure and if they do, trader’s should expect the credit markets to remain firm. The benchmark 10yr Notes have diverged from the upper Bollinger band and have failed to even tag the upper band since April 26^th. Outright 10yr futures continue to trade above the 9 day moving average, a sign that the short term trend remains higher. Yet it should be duly noted that spreads on the long end are showing hints of weakness. The 1:1 5yr/10yr spread has moved lower to tag and hold the 9 day moving average while the 1:1 10yr/30yr has broken below and even gone down to test and hold the 20 day moving average. As the spreads can sometimes give early warning signs for trend shifts, it is worth looking at potential short entries in the credit futures today especially if the equity markets can maintain a strong bid throughout the day.

Despite Breach of Debt Ceiling, Treasury Continues to Issue Notes and Bonds

Mike Marshall — 2011-05-24T14:54:00Z

Mike Marshall

Account Executive

1-800-216-1485

mmarshall@pfgbest.com

In keeping with the theme of our last post, it is duly noted that the Treasury is continuing along with the scheduled 2yr, 5yr, and 7yr auctions this week. Today’s $35B 2yr Note auction will be interesting to watch. Clearly, the markets have shrugged off the breach of the debt ceiling as a cause for concern. To be fair, why should they? The real fear is that the US will not be able to cover its commitments, and Treasury Secretary Geithner has made it clear that he will plunder the government pension funds in order to cover these public debts and is already in the process of doing so.

As the short end and belly of the curve has been well bid by the Primary Dealers, who know that the FED will quickly come knocking to buy back large quantities these of newly purchased notes, I suspect this week’s auctions will go off without a hitch.

For the topic of QE3, I will go back to some of my previous commentary on the subject. Whether it is called QE3 or something else, I firmly believe that the FED will have NO OTHER OPTION but to continue stimulus in the bond market. The FED currently believes that the current inflation shown in the commodities sector is “transitory.” This statement alone gives the green light to continue monetizing bonds and notes in order to maintain a low rate schedule. From one perspective this makes a great deal of sense. The US economy is still weak, and an increase in borrowing costs could kill any semblance of a sustainable recovery started in the past several months. Unless the world decides it wants US debt at near record low rates of return, I do not see how another alternative is possible lest the FED wishes to see what a big crash in the bond market looks like.

At the moment, the credit environment in Europe appears far worse than ours. Just yesterday, Fitch downgraded Belgium’s outlook to Negative; S&P has done the same with Italy; and the US has agreed to back $1B in Egyptian 5yr Notes. Foreign credit concerns could be enough to keep demand up for US debt securities and the near term direction for US Treasuries is expected to be mixed to higher.

US Breaches the Debt Ceiling. Markets Shrug.

Mike Marshall — 2011-05-16T14:54:00Z

Mike Marshall

Account Executive

1-800-216-1485

mmarshall@pfgbest.com

Apparently the fact that the US is now technically default on its debt obligations is not really much of a story. At least the markets don’t appear to care much. Perhaps traders are now used to all the posturing done by Congress and realize that the current impasse is just a way for certain parties to extol yet even more bargaining power to support their cause.

Nonetheless, at the time of this writing, the Bond and Note futures actually stand higher on the day, meaning that yields have actually gone down a bit. That being said, there is clearly an absence of aggressive buying going on either. From the mid-day perspective, markets appear to be in a holding pattern.

Of course, some of this non reaction could be coming from this morning’s news that China had two failed bond auctions in 1yr and 6 month durations. Apparently, Chinese bond buyers did not agree with the measly 3% return given on one year notes considering the rampant inflation pressures now hitting the Chinese.

The weakness in the stocks, most notably in the NASDAQ, may also be supplying some short term safe haven buying in the bond markets as well, though I think that in the end, traders may not care about a breach of the debt ceiling. At the very least, traders must expect some form of resolution is forthcoming despite calls for trillions in budget cuts accompanying a hike of the debt ceiling.

Though I do not expect a resolution today, I do expect that Congress will get its act together before the early August Recess. Coincidentally, this falls precisely at the edge of when Treasury Secretary Geitner claims the extraordinary measures taken in order to continue funding current credit obligation will no longer be enough.