Bond Yields

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After the release of the Labor Report on Friday the market made an interestingly strong move into the close. The Labor Report had better than expected headline job creation, which initially sent the market higher. Then, as we peered into the report, we saw some rather discouraging items. First, while the U3 unemployment rate stayed unchanged at 7.6%, the broad measure of unemployment shot up from 13.8% to 14.3%. Then when we looked into the job creation numbers we saw that the big boost in job creation came from part-time, rather than full-time work. The pre-market futures started selling off sharply and the day looked as if it was going to be a non-event, a flat market. However, the market turned around and ended up closing strong, despite some of the concerns. All eyes are now on bond yields.

Bond Yields?

With the long-dated bonds falling and bond yields moving higher, there is a lot of focus on the bond market. What is interesting is that the Federal Reserve has made it clear that they will keep short-term interest rates at zero through 2014 and perhaps 2015. The recent talk about tapering has nothing to do with interest rates, but rather their bond and MBS purchase program. So, the move in interest rates was interesting and came suddenly. Those holding long-term government bonds have seen some significant unrealized losses of late.

We all knew about a bond bubble and how the bond market couldn’t go much higher. 10-year bond yield had reached 1.5% and seemed a little ridiculous, regardless of how low government stated inflation was. However, I didn’t expect that we would see a panic rush out of the bond markets which sent yields higher. Then, after a cool off period, on Friday we again saw a rather huge spike in bond yields from, 2.5% to 2.73%. I didn’t think the Labor Report (once you look beyond the headline) definitively confirmed that the Fed would taper.

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This morning the headlines read “Goldman Sachs say that treasury yields will rise to 4%.” The headline make it seem as though that could happen in the next couple of days or weeks, given the way this bond market has been behaving. However, once you read the story, it is projected for 2016 (over 3 years from now). That’s not a risky call and I think the majority of us believe that could very well be the case.

The Bond Story

However, with all this bond market volatility, which is also driving volatility into the equity markets, there is one variable we can’t account for, the Fed! If we look at the bond market, the taper talk, and the Federal Reserve monetary policy, the story seems to write itself.

The Federal Reserve is currently the largest purchaser and holder of US bonds. They want to taper and start reducing their balance sheet, but they can’t, not with interest rates this low. NO ONE is willing to buy 10-year bonds yielding 1.5 – 2%. So in order for the Fed to taper they need OTHERS to purchase bonds and the only way that others will purchase bonds is to allow rates to increase (making them attractive). The low interest rate environment, while helping home purchases, has been killing savers and the fixed income. I guess you could say the first few years the mortgage market was given a gift with a super low interest rate environment at the expense of fixed income, savers, and pension funds. Now it is the fixed income arena’s turn to get some better yields and perhaps the mortgage market can handle some slightly higher interest rates. If the 10-year bond yield slowly gets up to 3% and then perhaps 4% (even by 2016), it will certainly be high enough to attract investors and allow the Fed to taper their bond purchases. Perhaps they could even taper this year, if the bond yield stays up in the 2.7 – 3% range, but that will be determined on how much long-term bonds the government issues, which is based on how much deficit the government is running.

The pain now is for those holding bonds and watching them decline. If Goldman is right, we could be in for a couple of years of declining bond prices, which is going to be a slow pain for bond holders. The Fed will have their hands full keeping the bond declining in a controlled and steady pace. They certainly don’t want to see a mass exodus which sends bonds falling precipitously and spiking yields to 4% in a matter of months or weeks. Headlines, like Goldman’s forecast, don’t help and could lead to some heavy bond selling.

So, while we saw recent volatility and spikes in bond yield, it may cool a bit and the Fed is going to do whatever they can to keep this bond sale from turning into a panic sale.

However, there remains an interesting divergence in this story; the Fed is still keeping (and plans on keeping) the short-term interest rates at Zero. This steepening of the bond yield curve can be a huge boon for the banking sector, as they are able to borrow at zero from the Fed and lend out at higher rates. It also opens up room for bond arbitrage between short-term / long-term bonds. I am not sure how steep they will allow the bond yield curve get; perhaps Goldman is letting us know it will be stopped out at 4% in 3-4 years.

RUT tale of the tape

As I’ve mentioned in the previous Market Previews, it seems the RUT index has remained stronger and reflects that order flow is still strong in equities (despite the other index volatility). It would seem that the RUT was the leading indicator for equities as now we saw the other indices bounce higher on Friday and play catch-up to the RUT index. I have always believed that the RUT is a better broad-based indicator of order flow in/out of the equities market. It remains stronger and that seems to coincide with this change in long-term bonds.

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FOMC Volatility

We do have some volatility this week with the FOMC minutes on Wednesday followed by a Bernanke speech. We know how the last few FOMC minute releases went (sending the market up and down sharply) Then we have another FOMC meeting upon us at the end of July, which will again set the tone for the close of summer. The Fed is then in a quiet period until September.

Larry Summers’ Tantrum!

There is also news that Larry Summers could be the favorite for Bernanke’s job; however, I believe the WSJ story about Summers didn’t come from the White House, but rather something that Summers, or someone close to him, said . There could be a little bit of Summers / White House feuding going on as Summers had been rumored to take Bernanke’s job back in 2009. Summers had taken the job as economic advisor to the White House back in 2008, with (I assume) some aspirations or perhaps a promise from the White House to be the next Fed chair. Then President Obama nominated Bernanke for another term in 2009. Stories circulated that Summer’s was frustrated that he was not chosen to take Bernanke’s place and he shortly left his position at the White House for the private sector. So it seems to me that the leak that Summers is a favorite did NOT come from the White House, but perhaps from Summers himself or someone close to him. Perhaps a little reminder of the failed promises from the first time? I still think Yellen is the front runner; one only has to look at Obama’s predilection for choosing woman in prominent roles and this would make history as the first female Fed Chair.

Larry Summers

Support & Resistance

INDU 15,000 / 15,400
It was just the last couple weeks that 15,000 had turned into a straddle strike and looked to be a new resistance level. Heading into the Labor Report it seemed like we may sell off back to the recent lows of 14,600 before bouncing higher. However, that was not to be, after a late session strong rally in the equity markets that pushed the index up to 15,135. This morning it looks like we may get another 40-50 points at the opening. Now we head into earnings, will they, too, surprise? They are expected to be on the weak side, so any upside surprises could send the market higher.

NDX 3000
We are on our way and can certainly get there this week. It also appear that the whole Dell story looks like it is coming to a close and Michael Dell may yet be able to take his company private. Apple (AAPL) seems to be getting a new lease on life, as well, as it has bounce back from below $400 and news about the new iWatch looks like it may debut by year-end. I continue to believe we are at the beginning of a new technology revolution in Big Data and Cloud Computing, which can fuel this index higher, with the right players in the mix.

SPX 1650
The SPX broke above that 1625 level and is making a run on 1640 – 1650. The pre-market futures are up slightly, so I would expect a higher opening. The VIX has come down below 15 after Friday’s run and we could head back down to 13 this week if the market continues to run higher; however, I would look at hedging longs if the VIX gets back down to 13 or below and the SPX gets to 1660 – 1680.

RUT 1000
The RUT, as I mentioned, has remained strong and has been constant in showing order flow into equities. The bond move lower confirms that money continues to flow into equities. The RUT is like the turtle in this race, slow and steady, as the Dow and SPX are more like the hare and far more volatile and uncertain.

Is 2013 the year of change in the bond / equity market? Are we finally getting back to normal? I’m not so sure; not yet. I think the biggest variable will be the new Fed Chair, whom I suspect it will be Yellen. She believes that the economy needs far MORE stimulus and wishes to increase asset purchases rather than taper. She is certainly a huge variable as it seems that Bernanke wants to get back to a normal bond/equity market with less Federal Reserve intervention; the time of government intervention is over (or should be declining) in his eyes. Yet it also seems he has fallen out of favor from the more Dovish members of his ranks and from the White House. Could Yellen put the brakes on any kind of taper?

I also believe the taper talk is just that, talk. The Fed doesn’t decide if it will taper, the laws of supply and demand are the sole determiners. If there are enough buyers in bonds, then the Fed can taper; if there are not, they are unable to taper, even if they wanted to. So all this talk about them making a decision is a little silly, of sorts, and I think the focus should be on whether they CAN rather than if they wish to or not.

As bonds continue to decline and bond yields become more attractive I think that the possibility of a Fed tapering is certainly a real possibility; however, a lot of this also has to do with the Federal deficit and the bond issuance. The Federal Government could turn to short-term paper to avoid issuing more bonds at higher rates (which they can’t really afford). Perhaps we see the Fed taper in long-term bonds, but also fewer long-term bonds issued at higher rates.

Now our focus must turn to earnings. The expectations have been set for a weaker than initially expected earnings season (primarily top line revenue and sales). I think that if we get any upside surprises it could further fuel the equities market higher and also send bonds lower.

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