The Hightower Report

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The Treasury market was obviously caught assuming the worst for the economy, as a series of slightly better than expected scheduled data points served to knock down Treasury prices aggressively yesterday. With the equity markets also launching into a sharp short covering relief rally in the wake of the scheduled data flow from the US yesterday, that seemed to make the macro economic reversal even more significant in scope. However, the numbers released yesterday were 2nd and 3rd tier economic readings and the readings weren’t overly impressive. However, the bear camp can certainly suggest that Treasury prices at the highs Wednesday were factoring in a fairly broad based sustained slowdown. Clearly the ISM manufacturing report caused the greatest reaction as that report offered the most concrete evidence that the US economy retained some positive momentum. Given the reaction to the ISM readings yesterday, that should make the US Factory Orders figures today a fairly important release. In fact, the ISM figures were so far off the general consensus of expectations that the Treasury market seems to have seriously called into question the entrenched view of slowing that had served to lift Treasury prices over 8 full points in the month of August. Some of the sellers in Treasuries yesterday were probably exiting positions because the stronger than expected ISM readings served to reduce the odds of further easing by the Fed. However, the market will still be presented with a very significant amount of economic news over the coming two trading sessions and the tone of these numbers are likely to send nearby Treasury prices away from current price levels which are almost at the middle of the last two weeks trading range. The bear camp probably needs to see additional evidence of resiliency in the US economy to engineer more declines ahead, while the bull camp probably needs to see evidence that the US economic track is still somewhat suspect. The ultimate arbiter of the trend is still likely to be US Non farm payrolls on Friday and not the numbers today but some traders think the better than expected US numbers yesterday, set the market up to absorb weak US payroll readings Friday without as much upside momentum. In the near term, the market will probably see the weekly claims data as a slightly more important report today as there has been some doubt cast upon the double dip recession view and therefore all numbers look to be important to the trade again. While the Press attempted to play up the talk of a bond bubble in the wake of the sharp setback in Treasury prices yesterday it will still probably take a distinct pattern of somewhat favorable economic news to prompt a sustained rotation away from fixed income holdings and back to equities. While the slowing crowd was certainly dealt a blow with the better than expected readings yesterday, it would surprising to see the numbers suddenly turn positive and the fear of slowing completely tossed aside. However, with the recent high in bonds (August 25th) coming on a significant pulse up in trading volume and spike up in open interest, some traders are suggesting that prices were technically overextended. Not surprisingly, the market discounted a very sharp drop in August auto sales at GM yesterday and that reading probably makes the Factory orders report today slightly more important than the claims or productivity figures. With the slightly better than expected ISM readings yesterday and the last remarks from an outgoing Fed President, downplaying the expectation of direct easing from the Fed, the productivity readings this morning might carry less weight than normal.

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The Treasury markets reached another peak yesterday in the wake of a one/two punch of much weaker than expected US existing home sales figures and noted weakness in US equities. Recently the Treasury market wasn’t being presented with enough weakness in the equity markets to markedly degrade macro economic sentiment, but in the Tuesday trade, the market was presented with what seemed to be a roundly bullish overall environment. With the market also seeing a favorable US auction result in the trade yesterday and statements from the Fed suggesting the odds of a double dip recession were growing, there were a number of unrelated events that favored the bull camp. In looking ahead, the markets might be set to see a somewhat positive US Durable goods report, as the range of estimates for the Durables are mostly touting a “positive” reading. However, in the event that the durable goods report fails to meet most expectations, the trade could still come away from the report with ongoing concern toward overall growth in the US economy.

Since the Fed’s economic symposium doesn’t officially kick off until later this week that could reduce the flow of Fed dialogue today but we suspect that the market will be on the hunt for any statements from Fed officials in transit to the meeting. The market will be presented with another auction today of $36 billion in 5 Year notes and given the strong bid to cover ratio in other issues recently, many traders think the auction results will continue to be lightly supportive of Treasury prices.

While the Press was already touting the prospect of a Bond bubble in the headlines over the last several months, yields weren’t as low as they are now and the Notes and bonds weren’t “net Spec long” in the weekly Non Commercial and Non reportable COT positioning reports. With many US Treasury yields so low, that a minor pick up in inflation could present investors with a very minimal inflation adjusted return, the rational for snapping up US Treasuries could be called into question. However, as long as the fear of slowing and a double dip recession remains the focal point of the trade, Treasuries will probably stay in vogue.

In looking ahead to the scheduled data today, it is possible that rather dire macro economic concerns might be tempered slightly, as a housing report today isn’t expected to be as “headline soft” as the Existing home sales figures were yesterday and the durables report is actually expected eek out a positive result. With the range up move yesterday seemingly factoring in some form of additional quantitative easing move by the US Fed, some traders are suggesting that the official word on QE/asset purchases from the upcoming Fed symposium might result in a temporary peak in Treasury prices off a buy the rumor/sell the fact market reaction. However, others in the bull camp suggest that weakening in the economy is likely to continue and that the next US payroll report is likely to confirm the slowing and that could allow prices to make even higher highs.

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Treasury markets traded higher this morning in reaction to the Fed’s quasi move at quantitative easing. The Fed’s decision to reinvest the proceeds from maturing mortgage securities to purchase longer term treasuries has provided a bid throughout the yield curve. As a result, September 10-Year Notes forged another new contract high overnight, and that has pushed yields out to new 16-month lows of 2.717%. Yields on the 2-Year Note have registered a new record low this morning to trade under 0.50%. Global equity markets traded lower overnight led by a 2.36% decline in the Nikkei while European shares traded around 1.0% lower as they factor in recent measures by the Fed along with a downgrade to the U.S. economic outlook. Tuesday’s 3-Year Note auction was very well bid even though it registered a new record low yield of 0.844%. The bid to cover ratio was well above the recent average at 3.31 to 1, at the same time the final yield was one basis point under market levels at the deadline. Perhaps this positive demand will again surface in today’s $24 billion 10-Year Note auction.

The recent decline in yields (rally in prices) since Tuesday afternoon has the potential to make this auction a market mover. Additionally, part of the Fed’s treasury purchase program targets the 2-Year to 10-Year maturities and will be interesting to see how the market absorbs today’s supply. In fact, a noted bank analyst team indicated that the Fed’s purchase of Treasuries under the new plan could total $300 billion over the next 18-months, based on their current portfolio of mortgage securities. In other words, it is a far cry from the Fed’s tone just months ago when they sought out exit strategies.

Spread differentials between the 2-Year and 10-Year notes have continued to flatten out in response to the Fed decision and have come in to 221 basis points (settled 227 Tuesday).September bond futures continue to hold the uptrend pattern with key support levels that have ratcheted higher after Tuesday’s surge to stand at 129-03. There is a similar pattern in the September 10-Year notes, which now has support below at 124-09. However, of concern are technical momentum indicators that have become overbought during the recent advance and have begun to diverge from current high price levels.

The bulls have the edge to start this morning, but a favorable reading in this morning’s economic statistics or a disappointing result in today’s 10-year Note auction could disrupt the advance.

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The Treasury bond market looks set to start the US trade at the top of the recent consolidation and seemingly poised to probe higher levels. In the wake of the scheduled US data flow on Tuesday, the Treasury market has the justification to price in its concern for the US economy. With Pending home sales falling to a fresh record low reading, the trade actually saw evidence that hints at something more than a listless economic track. In other words, talk of a double dip recession enters the equation again and that in turn probably increases the focus on the scheduled data due out later today.

With the market swirling talk of renewed quantitative easing from the US Fed earlier this week that has also created a mostly bullish environment for bonds and notes. While initial expectations of a 50,000 to 75,000 Non Farm payroll loss on Friday morning, on its face, doesn’t seem to signal a huge contraction in the economy, for many that type of reading could confirm that the US economy is moving in the wrong direction. However, given the noted weakness in the US Dollar and the relative proximity to all time highs in Bonds and Notes, it is possible that Treasuries might have a marginally weaker Friday reading already factored into the equation.

At least in the near term, the Treasury market doesn’t seem to be overly concerned with oversupply or creditworthiness issues, but that might be the only angle the bear camp can hope to play up in the current environment. There will be a quarterly refunding announcement this morning, but it just doesn’t appear like the trade is poised to foment and embrace fears of rising supply. One would think that a slow economy would be producing reduced tax inflows to the US government and that in turn would manifest larger borrowing needs, but the US government is masterful in disguising its borrowing needs with accounting methods that would be considered illegal in the private sector. In other words, downside action in bonds and notes might be difficult to engineer in the near term, especially given the pattern of recent US data flows and a choppy to weaker global equity market track.

The bulls will suggest that bonds deserve to move back to and perhaps above the old highs, because of the additive influence of quantitative easing expectations from the Fed and with the renewed deflation fears in the marketplace it would appear that the bull camp has a pretty solid case. Initial resistance is seen up at the old high close of 128-27 and then again up at 129-07 in September bonds. Similar resistance in September Notes is seen at 124-08, which is the old high.

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The Treasury market surprisingly showed some weakness yesterday in the face of news that the US planned to undertake more deficit spending to pay for an extension of unemployment insurance. Congress was divided over cutting from the existing budget and simply adding the spending on to the overall debt tally. The GOP was apparently for the extension, but wanted the spending paid for with offsetting budget cuts. In the end, the Treasury market saw the prospect for more debt supply ahead as Congress was expected to pass the measure soon. It is also possible that part of the weakness in the prior trading session was the result of comments from a Chinese economist that China should reduce its exposure to US debt and part of the setback might simply have been the result of a better than expected NYSE stock market opening on Monday morning.

In the end, the market saw a decline in the NAHB Index and the softest reading in that report since the fall of 2009 and that kept the string of softer than expected economic readings intact. With the US housing starts and permits data due out today and the general expectations calling for weakness in those readings, we have to think that the Monday lows and the early morning lows today, are going to be solid support from which the Treasury market will attempt to work higher from.

We do think that this market is prone to becoming overbought and perhaps prone to temporary lapses of buying interest, especially if the Dollar fails again, as that action could chase away some foreign investors. In fact, part of the weakness in the prior trading session might have come from the combination of suspicions that US Treasuries were losing their flight to quality status. However, in the event that the housing permits come in weaker than expectations that could clearly rekindle the talk of a double dip recession and since the semi annual Fed testimony doesn’t start until Wednesday, that could give the double dip crowd 24 hours to lift Treasury prices.

The Permits number could be the key figure in the release schedule today, as that reading tends to be a leading indicator and therefore a bigger than expected decline in permits could be justification for Treasury bond prices to quickly return to their early July highs. Countervailing the upward tilt in Treasury prices is a sense that the European stress tests results at the end of the week are likely to see most financial entities pass. There are some concerns that a European real estate bank might fail the stress test but there are funds available to plug the holes for those in need of cash. In short, the bias is up with close-in support in September Bonds seen at 127-13, with similar support in September Notes seen at 122-29.

As suggested before, there might not be much in the way of resistance this morning if the housing data is softer than expected, but first resistance in September bonds is pegged at 128-13, with resistance in September Notes pegged at 123-13. The bear’s biggest risk today comes in the direct aftermath of the Housing Permits release, but the equity markets and the currency markets don’t seem to be overly sensitive to potential flight to quality issues within the Euro zone today.

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While yesterday’s US numbers weren’t that significant they continued to point to what appears to be a slackening US economy and that combined with a rather surprising drop in Canadian building permits date yesterday suggests that all of North America remains mired in a slow down of sorts. Certainly Treasury prices remain in favor, as a flight to quality instrument this morning, as the focus of the trade temporarily shifts back toward the Euro zone in the wake of a flurry of Press coverage on the bank stress tests. The Asian trade in Treasuries was slightly upbeat in the wake of indirect assurances that China wasn’t going to dump US Treasuries in an effort to exert pressure on the US.

Apparently Chinese officials indicated that US Treasuries would remain a key component of Chinese foreign currency controls. In the second quarter of this year, the Chinese reportedly held over $900 billion in US Treasuries, but when one considers the size of the Chinese reserve total of $2.45 trillion, the US holdings aren’t as egregious as many seem to think.

With a slack US economic report slate due out today, the focus of the Treasury market is likely to be on news surrounding the Euro zone bank stress tests, but since those result won’t be made public until February 23rd, the flurry of dialogue around the release of the criterion sent to the Euro banks, is likely to offer little in the way of major direction to US Treasuries and the US Dollar. In fact, with the Dollar showing a bit of strength today and the US equity market showing weakness that would seem to leave the bull camp in Treasuries with an edge to start the US trade today.

Overnight the Royal Bank of Australia indicated that Chinese and Indian economies remained strong and that the Australian economy was showing such strong demand that they would have to respond very soon, but apparently the bright spots in the global economy aren’t going to sway international equity markets, as they are showing a downward bias today.

In the mean time, US Treasuries look to remain within striking distance of their recent highs, with the flow of upcoming numbers potentially serving to lift prices back to their highs. We continue to think that Treasuries are going to be held back because of risk and reward fears associated with purchasing at such low historical yields. Critical support in September bonds is rather close-in at 127-28, with little in the way of resistance seen until the old high of 128-19. Initial support in September T-Notes is seen at 122-20, with little in the way of resistance seen until the old high of 123-01.

At least in the near term, the bull camp looks to retain the edge, as there is no scheduled data to fully alter sentiment and it doesn’t appear as if Washington is on the verge of launching a fresh stimulus effort. About the only way to quickly undermine Treasuries would be to see concerns toward the deficit take precedence over take the fears of slowing in the headlines.

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We had some very bad US data again today, but Treasuries weren’t been able to extend sharply to the upside, which leads us to believe that we might be near a major inflection point. While the Euro zone situation isn’t fully solved by any measure, we think their debt contagion has been moved to the back burner and that the slowing of the US economy and its soaring deficit problem might become the media’s new obsession. With the battle lines drawn in the recent G20 meeting, the US is already setting the stage for divergent policy decisions. Perhaps the US leadership was already aware of the vulnerable status of the US economy, but since Washington won’t do standard textbook stimulus efforts the US might be in for a return-to-recession status.

The world has already bid Treasuries into the stratosphere due to their flight to quality status and because of evidence of US slowing. But today the Treasury rally seemed to run out of gas, and the US Dollar appears to have finally caved in. This suggests to us that world sentiment is changing and that further slowing in the US could mean a flight from the US Dollar and from US Treasuries. While gold was down sharply today, the world might have little choice but going to gold because of the almost total absence of a sturdy currency.

It would appear that the US will now be forced to provide more quantitative easing or perhaps even another stimulus package. Since the current US Administration would rather shoot itself in the foot than to utilize standard economic principles in their easing programs, it is possible that US Treasuries and the US Dollar are poised to go from the “penthouse” to the “outhouse.” In our opinion the Democrats won’t/can’t change their principles of only helping those who don’t have a job, are not wealthy and don’t work on Wall Street. This means the Democrats are going to be faced with market action ahead that could insure a house cleaning in the November elections.

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The Treasury market remains near the upside breakout point on the charts this morning, despite the fact that US equities have effectively rejected a downside breakout seen last Friday morning. However, with the German DAX opening higher and the US equity markets also showing positive action early today that could have undermined Treasuries and in turn knocked them back away from the upside breakout point on the charts. However, we suspect that the market is still pent up for a continuation of weak scheduled US data as that has been the pattern for well over a month. Apparently the weekend G20 yielded little in the way of significant developments and that should make the US data a little more important this morning. We suspect that the Personal Income reading will be the main focal point from the Data flow, with Personal Spending and the PCE core Index monthly readings also critical news. However, the PCE Index reading probably won’t show inflation, it is likely to show deflation and that is why that reading could surprise the Treasury trade this morning.

It is probably a little early for the trade to begin considering the week ending US Non farm monthly payroll reading but in the event that today’s rather active flow of data is generally weak, that could turn the focus of the market back toward economics.

The Commitments of Traders Futures and Options report as of June 22nd for U.S. Treasury Bonds showed that Non-Commercial and Non-reportable combined traders held a net short position of 30,549 contracts, with the Note market showing its Non-Commercial and Non-reportable combined traders holding a combined net short position of 157,031 contracts. While the Bond and note position readings are probably understated, due to the rally forged since early last week, the data appears to show that the Treasury market still has technical short covering capacity.

We think the data this morning will either underpin the Treasury market, or begin lifting it back toward the late May highs, as we think the economy is slow enough to prompt Washington to act with additional stimulus measures. In fact, Obama would probably have went along with the G20 “company line” of reducing deficits this weekend, if he wasn’t aware of the slowing pace of the US economy and the need for incumbents to get the economy moving well ahead of the upcoming elections.

We see the market respecting fairly close-in support around the 125-11 level in September Bonds and at 121-15 in September Notes. As for resistance, we suspect that 126-00 will be very weak resistance in September bonds, with the next resistance level seen at the old high of 126-05. Similarly, September Notes have initial resistance at 121-25 this morning. We suspect that Treasuries will see new highs sometime this week.

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The Treasury market comes into the last trading day of the week sitting within close proximity to the top of the last months trading range. Apparently the sweep of very weak US economic data this week has become the driving force in the Treasury markets, as the European debt story has been somewhat quiet this week. In fact, economic news from the Euro zone overnight might be applying some minor pressure to Treasury prices early this morning, as April Italian Industrial Production was up rather impressively and the May German PPI report also showed a minor gain. However, in looking back to the US data flow this week, it will be difficult to discount the fear of slowing. In fact, the list of weaker than expected readings was expansive this week, with sharply lower Housing starts and permits, a jump in initial claims and the lowest Philly Fed manufacturing survey reading in 10 months. One might even suggest that Treasuries have clawed back to within 2 points of their highs, without the distinct assistance of fresh headline concerns from the Euro zone.

Surprisingly the flow of weaker US economic readings this week hasn’t undermine US equity prices yet, as sharp declines in equities can sometimes make the economic outlook feel even worse. Since there are no scheduled US data points today, that could take some of the upward bias out of Treasury prices, but seeing UK Borrowing for May come in below expectations, could provide a measure of support from the flight to quality angle once again.

In retrospect, the Treasury market appears to have forged a pretty strong set of consolidation lows around this week’s lows, and to take prices down consistently from current levels, is probably going to require a lot of very favorable economic data and apparently an even longer period of time without concerning Euro zone debt headlines. However, initial support today is pegged at 124-00 in the September bonds, with similar support in September Notes seen at 120-14.

As for the upside the market might not have the momentum today, to forge a new high for the week, which means that yesterday’s highs of 124-18 in September Bonds and 120-27 in September Notes could be effective resistance today. Even news that the US would sell $108 billion in supply next week, failed to undermine Treasuries and that suggests the buyers continue to outnumber the sellers by a decent margin. The lack of scheduled US data today, probably makes the direction of the equity markets, the primary driving force for Treasury prices.

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The Treasury market failed to see distinct flight to quality buying surface in the prior trading session. Somewhat surprisingly the Treasury market was unable to forge a fresh new high for the move yesterday, despite seeing a positive reaction to the 3 Year Note Auction and ideas that US rates were destined to remain low from a US Fed member. However, the Fed’s Hoenig remains a dissenting force on Fed policy, with that lone policy hawk reiterating his view that the US needs to raise rates later this year to avoid a track toward inflation. In our opinion, Hoenig losses a lot of credibility by suggesting that European travails weren’t going to drag on the US economy, because that area is only 15% of US exports. In other words, we have another official that is willing to discount an important component of the economy regardless of the historical ramifications of a double dip recession on a government and US Fed that are neck deep in debt!

Statements from the Fed Chairman were somewhat balanced in his speech yesterday, as he expected the US to avoid a double dip recession, but he conceded to an ongoing threat from the Euro zone situation. While international equity markets were boosted by talk of favorable Chinese export numbers overnight, we still get the sense that risk aversion remains in place, as US equities are modestly lower in the early trade today. In looking to the $21 billion in 10 Year Note auction later today, dealers expect fairly robust demand for the instruments, but we think that the market might see the typical 8 to 12 tick corrective slide in the wake of the auction results, as the longer end of the market usually sees a buy the rumor, sell the fact type reaction. While Greece GDP was reported to be down 1% overnight and that reading is a touch worse than the initial prediction of -.8%, we would suggest that a 1% decline in GDP is not as bad as the dire picture painted by the markets over the last 4 months. In short, it should be very difficult to remove the flight to quality bid from Treasuries today, especially since the US economic data flow today is thin, with the Wholesale Trade figures not expected to shift economic sentiment markedly.

In conclusion, we see fairly solid support under the market today, with the prospect of a temporary dip down to 123-30 in September bonds in the wake of the auction results. We see similar support in the September Notes down at 120-22, with the market probably set to take a lot of direction from the equity markets early in the trading session. In the event of a surprise break in excess of 1 point in either bonds or notes, we would suggest that traders consider the sale of just out of the money puts, as the Fed looks committed to holding interest rates down and the threat of deflation currently looks to be a prevalent market feature for the near future.