PFGBEST Interest Rate Comment

CHICAGO - Oct 16/09 - SNS -- Following is the interest rate futures comment from PFGBEST Research.

I Hear the Drums Beating and They are Getting Closer...

Eaven Horter:  ehorter@pfgbest.com or (312) 563-8165

As previously noted in Monday's report, bond markets experienced a retracement on October 12^th and 13^th from October 9^th's oversold conditions.   Post market close on October 13th, strong sell signals were present as corporate earnings from Intel beat expectations, followed by Abbott and JP Morgan the next day and a few mixed signals from the FOMC's minutes regarding the MBS purchase program.   This brought about a ¾ point decline in 10 year T-note futures and an 11 bps rise in 10 year T-note cash yields on Oct 14^th.   These events combined with better than expected initial claims data and an in-line CPI reading on October 15^th caused bonds to continue their downward slide; 10 year T-note futures fell  over 1/3 of a point and cash yields increased by almost 5 bps.   These movements were all in-line with our expectations and not much of a surprise.   As of the release of this report, earnings from Bank of America and GE were providing bullish sentiment throughout bonds as their disappointing numbers were a reminder that the consumer is still experiencing numerous pressures.      

Data from www.barchart.com:

   ZNZ9 ' 10 Year T-Note Futures  

V2Y0 ' 10 Year T-Note Cash Yield  

$DXY ' US Dollar Index  

As we begin to move through 3^rd quarter corporate earnings, it seems we're in for a mixed bag of results this time around with less focus on the effects of cost cutting and more on the true stability of consumer-driven sales.   While it's nice the markets are focusing a little more on fundamentals given these data, I still believe the USD is a prime driver of the current markets.  

After much consideration, I strongly believe the stock market's lofty levels have been caused by a 'reach for yield' as I've alluded to in past reports; borrow cheaply and put the money towards riskier assets.   The government is well aware of this effect and due to the loss in 'household wealth' over the past few years, I believe they are quite happy at the real wealth creation that has occurred within the stock markets since March given available low interest rates.  

With investors, mostly institutional, willing to purchase riskier assets, we've seen a migration back into the stock markets over the past two quarters.   Take a look at the chart below for the US Dollar Index since 2001; it's amazing to see the amount of 'flight-to-safety' investors that moved into the USD in 2008 as global markets imploded and conversely, the amount that have been exiting the USD since the beginning of the second quarter of 2009.   With the record low Fed Fund's rate in the US seemingly here to stay for at least a few more quarters, once can surmise that stock markets have the momentum and ability to continue their slow and staggered creep up and that the USD most certainly has more room to move down.  

I wouldn't be surprised to see the US Dollar Index approach $72 within the next two quarters if the US government continues to hold the Fed Fund's rate at current levels.   If this does happen, look for continued Commodity price strength, increased inflationary pressures overseas accompanied by relatively higher interest rates overseas, and potential actions from foreign central banks to stabilize the strengthening of their currencies.   I also believe markets will experience their 'breaking point' within the next two quarters and begin to correct both on dollar terms and within the stock markets; a little breathing/thinking time to consider the movements of the markets.  

(Chart from www.pfgbest.com)

What to Look for in the Coming Weeks:  Look for continued weakness in bonds beginning next week.   Although we should see mixed data, I believe investors will focus on inflationary pressures and improving business conditions.   Look for 10 year T-note cash yields to approach resistance at 3.60%, while staying in a range of 3.30-3.60%.   If data is amazingly positive, look for a potential move up to 3.70%, especially if the FOMC releases any new language regarding a change in their focus.   Look for a move down to 3.23-3.25% if earnings and economic data disappoint.   Look for 10 year T-note futures to trade range bound between 116 ½ and 119.   If earnings and economic are quite strong, especially if coupled with any new FOMC language about a change in their focus, I would not doubt a move down towards 115 ½.   Likewise, if data points to a negative outlook, look for futures to test the 119 ½ resistance level.   Look to buy near support levels and sell near resistance levels.

Next week will be a very, very full week of corporate earnings releases, especially Tuesday through Thursday.   Here's what to focus on:

 Monday, October 19^th: Apple, Inc. announcing after-market

Tuesday, October 20^th: PPI and Housing starts and the beginning of a heavy three-day sprint of corporate earnings

Wednesday, October 21^st: A heavy flow of corporate earnings

Thursday, October 22^nd: Initial claims and numerous corporate earnings

Friday, October 23^rd: Home sales and numerous corporate earnings

Trade Recommendations:

Short 10 Year Note Futures:

Sell December 119 Calls

Buy December 121 or 122 Calls

or

Sell December 10 year T-note futures above 118 ½, protective buy stop at 119 ¼

Sell Gold:

Sell Dec 1080 gold calls

Buy Dec 1110 gold calls

Required reading: If you haven't already done so, please take 30 minutes to read the FOMC meeting minutes from September 23^rd; the report is very informative.   I agree for the most part with the Fed's comments on the state of the economy and where we are headed; things have improved and are stabilizing.   However, I have a more cautious view of the current real-estate sector and feel we are in the midst of another foreclosure debacle, this time Prime related.   Additionally, I feel we will continue to see a high, range-bound level of layoffs as 2010 budgets are drawn up and we approach the first quarter of 2010.   If you don't have 30 minutes to read through the full report, the following excerpts are what stood out to me:  

'Although sales of distressed properties remained elevated, the rise in total sales of existing homes over the summer appeared to have been driven by an increase in transactions involving nondistressed properties. The apparent modest strengthening of housing demand was likely due, in part, to improvements in housing affordability stemming from low interest rates for conforming mortgages, a lower level of house prices, and possibly the first-time homebuyer tax credit.'  

'After narrowing to a 10-year low in May, the U.S. international trade deficit widened in June and July, as strong increases in exports were more than offset by sizable rises in imports.'

'Real gross domestic product (GDP) in the advanced foreign economies contracted more moderately in the second quarter than in the first quarter, with growth resuming in several countries.'  

'In the United States, core consumer price inflation remained subdued in July and August, as price increases in housing services moderated and durable goods prices declined. Overall consumer price inflation increased in August, boosted by a sharp upturn in energy prices, particularly those of gasoline.'  

'The spread between an estimate of the expected real equity return over the next 10 years for S&P 500 firms and an estimate of the real 10-year Treasury yield-a rough gauge of the equity risk premium-remained high by historical standards.'  

'Despite [these] positive factors, many participants noted that the economic recovery was likely to be quite restrained. Credit from banks remained difficult to obtain and costly for many borrowers; these conditions were expected to improve only gradually. In light of recent experience, consumers were likely to be cautious in spending, and business contacts indicated that their firms would also be cautious in hiring and investing even as demand for their products picked up. Some of the recent gains in activity probably reflected government policy support, and participants expressed considerable uncertainty about the likely strength of the upturn once those supports were withdrawn or their effects waned. Overall, the economy was projected to expand over the remainder of 2009 and during 2010, but at a pace that was unlikely to reduce the unemployment rate appreciably.'  

'Participants discussed the extent to which the size of the Federal Reserve's balance sheet would affect inflation expectations going forward. To keep inflation expectations well anchored, all agreed on the importance of the Federal Reserve continuing to communicate that it has the tools and willingness to begin withdrawing monetary policy accommodation at the appropriate time and pace to prevent any persistent increase in inflation."  

' Over the intermeeting period, the strengthening in the economic outlook led to an increase in investors' appetite for riskier assets.'  

'In particular, because the improvement in financial markets was due, in part, to support from various government programs, market functioning might deteriorate as those programs wind down. Moreover, credit remained quite tight for many businesses and households dependent on banks, and many regional and small banks were vulnerable to the deteriorating performance of commercial real estate loans. Participants noted that all categories of bank lending continued to decline. Participants emphasized that labor market conditions remained weak."  

'The household saving rate had risen considerably in recent quarters, and the most likely outcome was for the saving rate to remain near its higher level; however, some participants noted that there was some chance that the sharp drop in household net worth over the past few years, reduced access to credit, and high household debt burdens could lead households to save a substantially larger fraction of their incomes going forward.'  

'Also, some participants questioned whether the recent stabilization in house prices would be sustained as likely further increases in foreclosures would probably put downward pressure on prices.'  

'In contrast to developments in the residential sector, commercial real estate activity continued to fall markedly in most districts, reflecting deteriorating fundamentals, including declining occupancy and rental rates and very tight credit conditions.'  

' Participants marked up their outlook for foreign economies, mainly reflecting better-than-expected incoming data from a range of countries. The pickup in foreign economic activity, especially in Asia, had buoyed U.S. export growth, and several participants noted that higher growth abroad would support growth in U.S. exports going forward.'  

'Although the economic outlook had improved further in recent weeks and the risks to the forecast had become more balanced, the level of economic activity was likely to be quite weak and resource utilization low. With substantial resource slack likely to persist and longer-term inflation expectations stable, the Committee anticipated that inflation would remain subdued for some time.'

PFGBEST Research Team

Phone: 800-361-6855 or 319-553-2181

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