Market Update 2 9 11 _ Higher and steeper...where are we now?

 

The Pullback

 

From December 13^th to January 28^th the 10-year Treasury averaged around a 3.40%.  Then at the end of January it began a nice run to the upside and is now trading at 3.70%.  In two weeks we’ve had a 30 basis point improvement in yield on the 10 year Treasury.  On 1/28/11 the yield difference between the 2 year and the 10 year Treasury was 278 bps…today it is 287 bps.  So the yield curve today is both higher and steeper than it was two weeks ago.

 

Why?

 

There has been a range of economic data coming in a little better than the survey estimates over the last few weeks.  There isn’t a runaway trend of positive news by any stretch of the imagination, but when you’re down in the dumps any good news is reason to celebrate.  For example:

 

Personal Consumption was up 4.4% vs. the estimate of 4.0%

 

Michigan Confidence was 74.2 vs. the estimate of 73.3

 

Personal Spending up 0.7% vs. the estimate of 0.5%

 

Chicago Purchasing Managers report posted 68.8 vs. the estimate of 64.5

 

ISM Manufacturing posted 60.8 vs. the estimate of 58

 

Domestic Vehicle Sales of 9.59 million vs. 9.42 million…although GM and Chrysler are still using taxpayer money to subsidize their operations so I’m not sure this is a great number.  On a side note it really agitated me to watch tax-payer funded Super Bowl commercials that cost millions of dollars per minute…even worse they were pitching tiny hybrid vehicles that nobody wants to drive.  The one saving grace was the 426 Horsepower Camaro…but even that is using taxpayer money so it tarnished the whole thing a bit.

 

Inflation still under control as measured by the PCE deflator (the Feds preferred gauge)

 

Unemployment Rate dropped from 9.50% to 9.00% (it’s debatable if this is really good news as much of the change may not have come from people going back to work)

 

 

Wow…that’s a lot of good news…everything is better right?  Not really. 

 

GDP on an annualized basis posted 3.2% in Jan vs. a 3.4% estimate

 

Dallas Fed Manufacturing report posted 10.9 vs. an estimate for a higher level of 15

 

Construction spending was down month-over-month

 

Initial Jobless Claims still above 400,000 a month

 

Continuing Claims still running near 4 million

 

Payrolls data missed the mark by a huge margin in January

 

And it’s starting to sound like a cliché but it has to be said…the housing market is still a mess. 

 

 

So where does this leave us?

 

This is a bit of a staging area for yields.  Investors have been living with a lot of fear over the last few years.  Now that some of the fear is subsiding they are making some adjustments.  If you are a money manager banking on a recovery then you move early.  You sell Treasuries while you still have gains and you buy other risky assets while their prices are still fairly depressed.  Treasury prices drop (pushing yields higher) and the price of other risky assets (such as stocks) rise.

 

This adjustment process is more art than science.  If you move early and you are right then you post big fat positive returns, your shareholders love you, you get your picture on the cover of Bloomberg magazine, and you keep your job.

 

If you wait until you’re certain that the recovery will be robust and everything is going to be great again…then you’ve waited too long and you’ll get low prices on the sale of your Treasuries, stock prices will be higher than you wanted to pay, you will post returns far below your peers, you will be fired, and your name will be mud on internet investing forums around the world.  The early bird got the worm and you go hungry.  We’re seeing some of this now…the early birds are positioning.  Is it too early?  As with most things in economics it’s difficult to say for sure.

 

Clearly the fear of a double-dip recession has faded from the market.  The economy has some traction and has been able to generate a few positive bits of data to show that things are getting a little better.

 

However…there are still tremendous obstacles to be overcome.  Most people are still forecasting Unemployment to remain elevated for years, the Fed is still tracking core inflation that is running at levels below their target levels, and they are committed to holding rates low under those circumstances. 

 

Where does this leave us?

 

Currently it leaves us with a very steep yield curve and indications from the Fed that it will remain that way for an extended period (the survey data say Fed Funds will be unchanged through 1Q of 2012).  We have been given a very nice pop in yields over the last two weeks and this is widely viewed as a buying opportunity.  I don’t know of anyone that is calling for a continuous improvement in yields from this level…I’m not saying we couldn’t pop higher…but I know of nobody that is calling for it and we are already at record levels of steepness.  In fact this morning (with no data) we’re seeing some resistance.  The 10 year yield is dropping back below 3.70% and we’re hearing things like “oversold” in conversations about the Treasury market. 

 

It’s human nature to see a 30 bps run-up in yields and think “I’ll wait because it’s going to keep going up.”  Generally this leads to the next bit of human nature…the part where we say “Ah!  I should have bought while the yields were higher!”

 

One way to avoid this is to take at least some money and put it to work at these levels.  You don’t have to load the boat to take advantage of the pullback.  We do portfolio analytics for thousands of fixed income portfolios and those that perform best over time tend to be those that invest consistently rather than trying to time the markets. 

 

If you have liquidity lying around doing nothing you should be quite happy to see this pullback…the market has given us a great opportunity to pick up some yield that wasn’t there two weeks ago. 

 

And remember…if you call in and say “Ah I should have bought when rates were higher” it’s only human nature for me to say “Ah…I told you so”.   I wouldn’t really say that though…because you’d fire me. 

 

Yields on virtually everything are higher over the last two weeks.  The 3 to 5 year spot on the curve has seen a lot of activity due to the steepness…a small increase in duration garners a nice pickup in yield on this curve.  If you have any questions or if there is anything I can be doing for you just let me know.

 

Steve Scaramastro, SVP

800-311-0707