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Strategies & Market Trends : The Epic American Credit and Bond Bubble Laboratory -- Ignore unavailable to you. Want to Upgrade?

To: gregor_us who wrote (5940)	1/23/2004 11:05:13 AM
From: mishedlo	Respond to of 110194

Treasuries Return to an Important Level for Financial Markets Brian Williams Could have a big impact on equities if we break below three-month low yields We've written in the past that, in this environment, we worry more about lower Treasury bond yields (if accompanied by a pickup in bond volatility) more than we worry about higher Treasury yields. Yesterday's Treasury action brings us back to a significant point for financial markets. Yesterday, the yield on the 10-year Treasury fell from 4.02% to 3.95%, bringing it right back down to the area of the September/October lows of 3.93%. It also visited this area on Friday before bouncing to the 4.05% region. We've written how the current dynamics of the mortgage market have been producing big swings in refinancing activity for small moves in bond yields and how we feel that, should the 10-year fall below the 3.93% area with a pickup in bond volatility, mortgage investors will have to start purchasing long maturity Treasuries or their equivalent to hedge themselves against a further jump in prepayments. Such mechanical buying, if it were to get started, could have a significant impact on other markets. Such a fall in Treasury yields would have the potential to apply either the brake or the gas to stock prices. Which path stocks would take would take would most likely be determined by what happens to corporate spreads. It would be a negative for stocks if Treasury yields fell so violently that the drop causes government agency spreads to widen out, thus forcing corporate spreads wider at a time when companies are racing to market to roll over their maturing debt. This would be analogous to the 2002 experience, when investors fled corporate bonds and stocks for the safe-haven features of Treasuries. The near-meltdown of the corporate bond market that summer more than offset the positive impact of mortgage refinancings. A drop in Treasury yields would be a positive for stock prices if it was orderly enough that the fall didn't push corporate spreads significantly wider. This would be similar to the situation of early last summer, when we wrote that both the Treasury and corporate bond markets were applying stimulus together for the first time since before the Asian crisis, with the result that both the economy and stock market were able to work their way higher. If the latter scenario were to occur again, the short-term rise in stock prices could be stunning (though the long-term impact would be negative). We noted earlier this month that conditions in the corporate market have evolved nearly to the point that is reminiscent of the conditions that preceded the debt binge that helped lead to the equity bubble. Though we aren't yet seeing any brokerage advertisements about tow-truck drivers buying Caribbean islands with their day-trading proceeds, the stock price action since then (including parabolic moves in a number of individual stocks) makes us more concerned about the possibility of a bubble forming. The best thing that could happen would be for Treasury volatility to remain low, and for companies to take advantage of the rise in stock prices by making secondary equity offerings, instead of retiring equity as happened during the bubble. Such an increase in equity offerings could help temper the gains in the equity market to a more sustainable level, and would go a long way toward repairing the damage done to corporate balance sheets in the late 1990's. Given the tendency of corporate management to focus on the short-term along with their appetite for debt, we would be surprised if that happened to a large extent, which means that the bond markets will continue to have an outsized impact on the direction of equities. We are at currently at levels in the fixed income markets where that direction could become clearer very quickly.