Mish says its the jobs
=DJ OFF THE RUN: Bond Bulls May Face Another Economy Lesson
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By Michael Mackenzie
A DOW JONES NEWSWIRES COLUMN
NEW YORK (Dow Jones)--Betting against the resiliency of the U.S economy has upended bond market bulls in recent years.
Now another strike-out potentially beckons for 2006.
At the start of the year, the accepted wisdom was that the Federal Reserve would enact one more rate hike at the end of January, with an even chance of a final tightening in March. Moreover, in an ever confident display of long term planning, many bond market bulls were looking for a rate cut toward the end of the year.
As a result, Treasury yields across the curve were camped near the current federal funds rate of 4.25%. Less than a week ago, the bond equivalent yield of the three-month bill was around 4.36%, a shade under the 10-year yield of 4.37%.
But a recent string of solid data has shaken the bond market's sense of certainty that slowing data would terminate the need for rate hikes soon. And the bond equivalent yield of the three-month bill has risen to 4.44%, while the 10-year yield is up at 4.53%.
Bond market bulls have been unnerved by further evidence of an improving labor market. Weekly jobless claims for the week ending Jan. 21 arrived at 283,000 Thursday, the third reading below 300,000 in four weeks.
The bet of a slower economy that would push the Fed into rate cuts by the end of the year was built on the idea of a cracking consumer as the housing market imploded. But while housing could still crack as rate hikes wield the pain of higher borrowing costs, a solid labor market could help the consumer ride out the storm.
"People were betting the tapping out of housing would hurt the consumer, leaving the job market as the main point of conjecture," said Jim Cusser, portfolio manager at Waddell & Reed in Kansas City, with $1.7 billion of fixed income assets under management.
Better Labor Mkt Could Remove Cap On Yields
With jobless claims establishing a trend below the 300,000 level and the four-week average sitting at 288,750, the lowest since June 2000, "it is beginning to look as though there has been a real improvement in the labor market at the start of this year," said Ian Shepherdson, chief U.S. economist at High Frequency Economics Ltd. in Valhalla, N.Y.
In other words, the January employment report could deliver a number in the high 200,000s and continued strength in claims would also indicate robust February and March job reports. That's something no bond bull was expecting at the start of the year.
"The absence of sustained strong payroll numbers, in our view, has been a key factor holding down long Treasury yields over the past few years so this is potentially a dangerous development," said Shepherdson in an email note.
No surprise then that expectations of further rate hikes by the Fed are being pushed higher. The market remains certain of the federal funds rising to 4.50% from 4.25% next week. Beyond that, odds of a move to 4.75% in March are now around 73%, up from last week's 60%, while a move to 5.00% in May has been trading around 20% to 25%.
Obviously, there is still of plenty of data between now and May and a new Fed chairman, Ben Bernanke, - who is set to replace Alan Greenspan next week - for the market to reflect upon.
Still, many economists have been forecasting a funds rate of at least 5.00% for this year, a level the bond bulls have scoffed at and are still wary of accepting at this juncture.
For now, "a rate hike in March is in doubt," said Michael Kastner, head of fixed income at SterlingStamos in New York. However, he conceded a January payroll number in the 280,000 to 300,000 region would likely lead the market to fully price in a 4.75% funds rate for March.
Long End Faces Mortgage, Supply Pressures
The picture for longer-dated rates could well get a lot more interesting in the coming weeks.
Traders are mindful that February brings a Treasury Department refunding with the sale of three-, five-, 10-, and for the first time since August 2001, new 30-year debt.
"The sell-off is being driven by supply," said Kastner, noting dealers were left holding most of the $22 billion in two-year notes sold Wednesday.
That explains some of the pressure seen in long term rates. But there are also rumblings in the mortgage and interest rate swaps arena that could propel Treasury yields higher and steepen the curve further.
"If mortgages really unwind, that could have a real impact on Treasurys," said Waddell & Reed's Cusser. "Many investors have been buying mortgages as that's where the yield is."
Indeed, the first three weeks of January were marked by the solid buying of mortgages based on the idea that moderating economic growth and a near-term end to the Fed's rate hiking campaign would keep the yield curve flat and interest rate volatility low.
Now those assumptions may not hold, and because the value of mortgage securities is highly influenced by the level of underlying rates, a further rise in 10-year yields will hasten the liquidation of portfolios. And at 4.53%, the 10-year is poised for a breakout, say dealers.
That of course has many investors pondering the silver lining of the sell-off.
Kastner, for one, says a yield of 4.50% on the five year Treasury is attractive versus its current yield of 4.45%. And he notes that the market is currently running back and forth, given that the outlook over Fed policy remains still in doubt.
(Michael Mackenzie is a special writer and covers credit markets for Dow Jones Newswires in New York. Previously, he worked as an interbank broker of commodity and interest rate derivatives for eight years in Hong Kong, London, Toronto, New York and Tokyo.) |
