Bond Market Tremors: Making Sense of Last Week’s Market Gyrations
By Al Martin
(6-11-07) Last week we saw frenzied trading in a variety of commodities, most notably in the U.S. bond futures, when the 2- and 10-year cash bonds were able to hold a yield above 5%, prompting a massive derivative readjustment trade which exerted enormous downward pressure on the U.S. Treasury 2's, 10's, & 30's, lifting yields to levels not seen since 2004.
At the height of that frenzy, we saw the Sep. 30-year bond futures (USU) become severely oversold in early Friday’s trade, (June 8, 2007), with a low of 105.13, prompting us to issue an emergency buy recommendation. And, indeed, we saw the bonds lift 1½ whole points during Friday’s regular session, to establish a high of 106.29. That was a reaction rally to a severely oversold market, prompted by technical action in the cash Treasuries.
Now, this is nothing new. And we should point out that when yields on U.S. Treasury bonds establish what is called new benchmark rates, which occur in round numbers, there is invariably a sell-off in U.S. Treasuries, which creates a spike in yields above a round number, in this case, 5%.
When the 5% yields were held across the curve on a closing basis in Wednesday’s trade, it prompted a dramatic sell-off in the cash instruments, and consequently the futures, in a knee-jerk reaction.
However, what invariably happens around round yield numbers in Treasury instruments is that the knee-jerk reaction is followed by a decline in rates in the following days, a process which began on Friday.
As the rates come back down to test the so-called benchmark number,
in this case, 5%, what would we expect?
To give you an example -- the 10-year U.S. Treasury bonds, which broke and held above a 5% yield on Friday for the first time in several years, proceeded to rally up to a 5.25% yield by early Friday morning, a ¼ of 1% yield rise in a 2-day period, which, by the way, is absolutely unprecedented.
Although it may not sound like much to the unwashed, it is simply an enormous move in the bond market, which suggested by Friday morning that the bonds were severely oversold. And, indeed, we saw some correction.
What will happen, as always happens in the past, is the yield will drift back down to test that 5% level to see if the yield breakout is genuine. We feel that the yield breakout is genuine, but that the 10-year cash bond, which closed at 5.116% yield in Friday’s trade, with the USU’s going out 106.25, will probably come back to test the 5.026% yield range, which would translate into a further rally up to 107.19 in the USU contract. That is where we expect ultimately the rally that began Friday to go to before petering out.
Therefore we think that there are still trading opportunities on the long side in this contract as yields come down for the so-called ‘test of the benchmark area.’
We see that not all the market reactions can be fit into the economic drum banging that went on in financial media late-week. You did see the correct reaction in the metals, in both precious and industrial metals, which fell sharply in the last two trading days, particularly so in the industrial metals, under this belief that rates are now moving higher globally, and that inflation pressures are also increasing. Therefore, rates will be higher, inflation pressures increasing is going to mean that demand for industrial metals, for example, will be following.
However, and this is where the conundrum lies in what’s being proposed, which economic drumbeat now is being heard in financial media. One reason that the bonds had been under pressure for the last 4 weeks is because we have seen up-ticks recently in global industrial production and consumer confidence numbers.
There is this idea that global GDP will not fall as much as expected in 2007 because of these recent up-ticks in industrial and manufacturing numbers, and recent increases that we have seen globally in consumer and business confidence indexes – that, indeed, consumption is going to rise faster than expected and that is why the industrial production numbers are rising – to build inventories globally of manufactured goods, which are at admittedly low levels now.
However, if that, in turn, is the case, it does not necessarily follow that inflation would be created. Nor does it necessarily follow that increased consumer confidence translates into increased consumption. Indeed, we have seen consumer confidence numbers rising for the last 3 months. Yet we have seen personal consumption numbers falling.
If interest rates are moving higher, consumption is going to fall even more because the cost to purchase goods and services increases. And adjoining this is the fact that we still do not see wages, either domestically or globally, rising at the rate of inflation. Real wages continue to fall globally.
What market pundits on financial media are trying to use as a justification for all the market machinations last week don’t fit the scenario.
In other words -- Don’t listen to the pundits. I always recommend that. The first step of becoming a professional trader is this -- Don’t listen to anyone on Bloomberg or CNBC. That’s absolutely an essential place to start from.
You’ve got to listen to the markets -- and not to the pundits. What are the markets saying? Then never read too much into it.
The thing financial pundits tend to do is they try to extrapolate what’s going to happen in the future based on market reactions in one week, and never read too much into it.
The move in the bonds last week was technically propelled. There was no instigating economic factor other than the Bank of New Zealand raising its rates to 8% on Wednesday, which did take the market by surprise. But in the last analysis, the Bank of New Zealand and indeed the entire New Zealand economy is nickels and dimes. You didn’t see any of the major countries move to raise their rates, nor is it likely they are going to. Don’t try to read economic tea leaves based on technical moves in the bond market that, as of right now, no one knows if those moves to new yield levels are actually genuine or not.
Industrial metal prices have been falling, and you continue to want to short the copper on rallies, a strategy we have been recommending for 4 weeks, and a strategy that has worked for 4 weeks. The precious metals, however, are reacting differently, for a different reason. The reason they came under pressure is because the U.S. dollar rallied as Treasury yields fell, which is correct reaction, and as the dollar rallied, it pressured gold and silver prices. That’s a pretty simple equation.
However, we see in recent weeks how closely tied the dollar has been to gold and silver prices, which is a link that is much more solid in the minds of the unwashed traders than it is among the washed. However, what I would believe is that you are likely to see on Monday a rally in gold and silver because it is likely that the U.S. dollar will start to back off, as it did Friday, as the bond market rally likely continues for another day or two. Therefore, I would expect the precious metals to rally and the industrial metals will likely have some sort of short-covering bounce. But the fundamentals in the industrial metals are certainly still negative.
Up-ticks in industrial production are going to negate dramatically increased production of industrial metals. And the enormous increase in industrial metals supply that is coming in the second half of this year (that will not be negated because we doubt, and even the U.S. Fed doubts, that recent up-ticks in industrial production are sustainable), this is simply an up-tick to rebuild low global inventories of goods.
So -- do not try to read a whole new batch of economic tea leaves based on last week’s gyrations in the bond market. Do not change your investment decisions or change anything, because, as of now, it is strictly a trading market.
We think, then, from a traders’ standpoint, and we believe there is still some more rally yet to go. And, indeed, there is much historical precedent to suggest that in these technical moves in the bond markets there would still be further rally in the bond futures contracts early next week, as that 5% yield now gets retested from the top side – in other words, coming down instead of coming up.
This new benchmark concept that cash rates in the 2's, 5's and 10's are going to remain above 5%, that that’s going to be a new floor and interest rates rise steadily from there – the economic calendar at this point would not suggest that.
In other words, we have not seen an increase in inflation, indeed, in the last 3 months. We have seen nothing but down-ticks in inflation globally. We have not seen any up-ticks in real wages globally or domestically.
Thus we believe that there is a legitimate reason for this and that this is simply a temporary increase in industrial production.