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Tuesday, June 29, 2010

Rosenberg Daily: Bonds

Long but good.  Rosenberg, 6/29:  For the record, the yield on the U.S. two-year note closed at a record low yesterday, at 0.625%. Think about that, we are supposedly in the first year of a reflationary economic expansion, and the two-year note yield has fallen to an all- time low. The 5-year note is down to 1.83%; the 10-year is at 3.02%; and the long bond is 4% on the nose. These are all new closing lows since the economic recovery began a year ago.

Yield activity will likely remain pressured to the downside. How can all the portfolio managers who are underweight the Treasury market show how short of a duration they are ahead of the quarter-end? Moreover, the net speculative short position by the non-commercial accounts on the Chicago Board of Trade (CBOT) is still massive at nearly 109,000 contracts on the 10-year note; although down from nearly 270,000 net shorts back in mid-April.

So, here we have the net speculative short position being squeezed by 161,000 contracts over the past three months and the yield has plunged 100bps. There is another 109,000 contracts to go just to get “flat” so that has to be worth at least other 70 basis points of downside potential. Remember, when we got to the yield lows back in late 2008, that was on a credit-induced panic. At the bottom in yields, the speculators had gone net long the 10-year note by some 40,000 contracts. We are still light-years away from that – there are still shorts to be squeezed as the bond bears run for cover.

Moreover, this current down-move in yields is not happening on some TARP- related panic or talk of Armageddon, but on a growing realization that deflation, at least of a mild nature as it pertains to the Consumer Price Index (CPI), is inevitable. This is an economic event, not some technical or panic-related event like we had in December 2008. As a result, this rally in the bond market is not likely to reverse course, though we readily admit that it won’’t move in a straight line either. At the late-2008 lows in yield, all it took was any government action to stem the panic to cause bond yields to back up and the equity market and other risk assets to rally dramatically. So, we had bank bailouts, stress tests, accounting changes, massive fiscal stimulus, housing assistance across a variety of fronts, and a huge expansion of the Fed balance sheet.

If we are wrong on the direction of market rates from here, it is because Uncle Sam has another rabbit to be pulled out of his hat. However, without some major exogenous positive shock, slower economic growth and mounting deflationary pressures will be the order of day. Over the past decade, the long bond yield has averaged nearly 250 basis points over the rate of inflation; so it would stand that if, at a minimum, we morph into the land of stable prices, we could see the long bond yield converge at 2.5%. That seems like an outlier to be sure, but the most dangerous thing to do in a credit collapse cycle is to rule anything out. Did anyone ever think that a 10% budget deficit-to-GDP ratio would ever coincide with a decline in the real 10-year yield (as measured by the TIPS market) to a mere 1.1%.  (My bold)

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