Hi Raymond.... TICK indeed -g- I've been impressed with two of Louis R's guests the past 2 weeks. Ed Hyman, two weeks ago and James Barrow this past week. ( I'll get back to Ed Hyman later).
Louis Rukeyser talks with the manager of one of the largest mutual funds in America, James Barrow, of Vanguard's Windsor II Fund. The panelists are Ed Brown, Frank Cappiello and Kim Goodwin.
Barrow runs one of the biggest value oriented equity funds in the world and has a great track record.
I thought his comment that the yield curve should flatten in 2002 was definitely on the mark. It seems that shorting
the shorter end of the yield curve say the 2 year note and going long the 7 to 10 year portion of the yield curve could be a good positional trade to put on and hold going into Q2 or even Q3. With a stop loss of course.
This article below highlights additional technical considerations as to why the 2 year note could well underperform say the 10 year note, over the next few months.
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More Debt Floating in the Bond Parade
By Brian Reynolds
Special to TheStreet.com
01/30/2002 03:56 PM EST
URL: thestreet.com
A lot has changed since October. Back then, I said I thought the Treasury would accommodate its increased borrowing needs by emphasizing auctions of shorter-maturity issues.
A week after I wrote that, the Treasury not only opted to issue more shorter-term debt, but it also decided to eliminate issuing 30-year bonds, sparking an incredible rally in long bonds, followed by an even more massive selloff.
I've supported the Treasury's effort to bring long rates down (though it hasn't had much effect) because I've felt that the economy needs lower long-term rates more than it needs lower short-term rates.
Now, however, estimates for the budget deficit have deteriorated further. From August to October, estimates for a 2002 surplus sank from $150 billion down to zero. Analysts are now forecasting a deficit of $20 billion to $50 billion. The additional borrowing, coupled with the time of year, could have a big impact on the two-year Treasury.
The chart below shows how dramatically the Treasury has increased its borrowing in the short end of the market recently. While obviously other factors besides issuance determine a security's yield, dramatic changes in borrowing patterns can have a big impact.
In 2000, the size of the monthly two-year auction was cut by one-third as the government rang up massive surpluses. This relative scarcity is at least partly responsible for the two-year's yield trading below that of the fed funds rate at the time. Now, the auction size has been increased 2 1/2 times from the $10 billion level that prevailed for most of the preceding year and a half.
Given the massive increase in auction size, it's no surprise that the spread between the two-year and the fed funds rate has gone from 11 basis points in August to 127 basis points now. However, despite the increase in this spread, I still don't think the two-year is attractive yet.
One reason is the possibility of an economic rebound. Although I believe the economy will begin to recover soon, I think it'll have a hard time accelerating strongly if long-term bond yields remain high. However, if the economy comes back more forcefully than I believe it will, I think the two-year is vulnerable to a selloff.
Also, we're moving into the time of year when the Treasury's borrowing needs are seasonally high. Whether the government runs a surplus or a deficit in any given year, the government borrows heavily in certain months and pays down debt in other months. The chart below shows the month-to-month change in the amount of Treasury debt outstanding over the past five years.
The Treasury is often a heavy borrower in February and March because early tax filers tend to get refunds. According to the Treasury's statement Monday, the government expects to borrow $60 billion this quarter, up only a little from the year-ago $51 billion.
I think this number is doable, but there's little room for error. Refunds will probably be higher this year than last because of the weak economy and because some payroll deductions weren't adjusted in time to take advantage of last year's tax cuts. A reason why the increase in government borrowing is projected to be small is that the Treasury plans to run down its cash balance, ending the quarter with only $20 billion instead of $30 billion.
The government tended to underestimate revenue when it was swinging higher; my fear is that it may be overestimated as it swings lower. If so, the planned tight cash balance would necessitate unplanned borrowing.
When April rolls around, the government pays down debt, as late filers tend to owe money. However, the past few years have seen heavy capital gains payments. That won't be the case this year. The Treasury has at least partly planned for that to happen, estimating that the government will pay down only about half as much next quarter as it did last year. I have the same concerns about the estimates of capital gains payments as I do about refunds. Again, with little wiggle room in the cash balance, there might need to be more borrowing than expected.
The good news is that, with the introduction of the four-week Treasury bill last summer, the Treasury has an instrument that can handle the bulk of unexpected cash swings. There is the potential, though, for the size of the two-year auctions to increase further. If that happens, then I think the two-year-to-funds spread needs to be wider.
In two of the past three two-year auctions, the bid-to-cover ratio has dropped to very low levels. This means that bidding interest by investors relative to the size of the auctions has fallen. While the absolute level of bids has risen from about $25 billion last summer to $39 billion now as investors have focused on safety, the auction size has increased at a faster rate. If the size of the next few auctions were to approach $30 billion, I think yields would have to rise to attract a sufficient number of bids, especially if the economy improves and investors focus less on the "safe-haven" qualities of the two-year.
This doesn't mean that two-years can't make money for you, especially if oil prices stay contained and inflation trends down. But, given the steepness of the curve and the small margin of error in the Treasury's assumptions, I don't like the risk/return trade-off. If the yield on the two-year were to rise another 20 or 30 basis points, without long yields coming down significantly, then I'd be more interested. |
