Wednesday, January 04, 2006

Katie Benner of TheStreet.com is getting closer

When will we get a reporter to announce that foreign governments buying of the T-Bills do to our surging dollar are driving mortgage rates lower? We are coming closer on this one...

Bond Brief: Another Inversion

By Katie Benner
Staff Reporter
12/29/2005 4:07 PM EST
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Updated from 2:20 p.m. EST
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The yield curve inverted for a third straight session Thursday following a two-year note auction that left the market nervous about foreign demand for U.S. debt.

Immediately following the $20 billion auction of two-year notes, the yield on that security hit 4.40%, while the 10-year yield remained at 4.37%.

The benchmark 10-year note ended the day up 2/32 of a point to yield 4.36%, while the two-year lost one tick to yield 4.37%.

The 30-year bond added 6/32 to yield 4.52%, and the five-year note was little changed on the session, yielding 4.34%. Bond prices and yields move in opposite directions.

The auction and the subsequent inversion left the market nervous about the health of the economy and will set the tone heading into Friday's truncated trading session and another long holiday weekend, said Peter Cardillo, chief market analyst with SW Bach & Co.

The result of the sale was mixed, with the bid-to-cover ratio, which measures demand, coming in at a relatively strong 2.42. The last 12 sales have produced an average cover ratio of 2.16. But indirect bidders, including foreign central banks, took just 30.6% of the auction, below the average around 35%.

In November, indirect bidders were awarded 41.4% of the notes, up from 36.1% in September, and the overall bid-to-cover ratio was 2.16.


Foreign buyers have been key players in Treasury auctions, recycling cash back into the U.S. through the purchase of government debt; net inflows into the U.S. hit a record high $106.8 billion in October, the most recent Treasury's International Capital data available. The Treasury estimates that overseas investors own about half of all government bonds, up from less than 35% in 2002.


"But foreign central banks won't stay away from the Treasury market unless we see a big decline in the dollar," said Peter Boockvar, equity strategist at Miller, Tabak & Co. "I wouldn't read into it too much."

He said that the selloff at the short end was largely technical, exaggerated by the thin, pre-holiday trading.


The bottom line for 2006 is the health of the housing market, Boockvar said, adding that it could mean the difference between 3% and 2% GDP growth.


At issue, he said, is the fact that affordability has deteriorated. Mortgage rates, including once-popular adjustable rate mortgages, are priced based on the 10-year Treasury; so the rate at which the 10-yield (presumably) rises will be closely watched.

"Even with 10-year yields modest, the cost of short-term borrowing and the rate of price increase have exceeded income growth for so long that that there had to be a slowdown," he said. "And low interest rates allowed consumers to overextend themselves."


If foreign buyers continue to shy away from U.S. debt auctions, Cardillo said, there would be negative long-term implications because foreign buying has supported the U.S. current account deficit and bolstered economic growth.


"Yields would also move higher [across the curve] " in such a scenario, he said.

Debating the Curve

The yields on the 10- and two-year notes first inverted Tuesday and continued to periodically flip-flop throughout the week.

The move sparked debate over the meaning of an inversion, the first in this part of the yield curve since 2000. Many wondered if the abnormal relationship presaged an economic slowdown or housing market problems.

Yields on shorter-maturity debt are usually lower to reflect the fact that investors demand higher yields on longer-dated bonds to compensate for additional inflation risk. An inversion between the 10- and two-year yields has preceded two of the nation's last three recessions, as well as a milder business slowdown in 1995.

Many economists, including Federal Reserve Chairman Alan Greenspan, say the yield curve is no longer a reliable leading indicator of economic health. Indeed, the inversion has sparked debate over what the move means in the current environment of robust growth and the global recycling trade.

Moreover, Hugh Johnson, chairman of the asset management company Johnson Illington Advisors, said that the spread most economists use to forecast what lies ahead for the economy is that between the 10-year and the 91-day Treasury bill or the fed funds rate.

This indicator is a component of the Conference Board's leading economic indicators, and the risk of a recession happening in the 12 months after an inversion in the 10-year and 91-day spread is 15% to 20%, Johnson said.

Forecast Mixed

Earlier Thursday, the National Association of Realtors said November existing-home sales fell 1.7% to 6.97 million, the first time monthly sales have come in below the 7 million pace since March. Analysts surveyed by Briefing.com had expected sales to come in at 7 million. The report also showed that median prices are up 13% from a year ago.

Talk of a housing market crash is overblown, says Michelle Girard, senior economist at RBS Greenwich Capital, but nearly all economists believe the market is slowing down.


While a leveling off of home prices is not bad for the economy per se, Americans have been extracting equity from their homes in order to maintain a blistering pace of consumption, which accounts for about two-thirds of economic activity.

Moreover, ramped up housing market activity has created a boom for construction firms, real estate agents and mortgage finance companies. Any slowdown in housing growth could mean slower job growth in these sectors.

Separately, the Chicago manufacturing index came in a little stronger than expected, edging lower to 61.5 vs. consensus estimates for a drop to 60.0.

Initial jobless claims for unemployment benefits rose by 3,000 to 322,000 for the week ending Dec. 24, vs. a consensus estimate for a rise to 320,000. But the four-week average of 325,000 -- sharply down from the 405,000 peak reached just after the Gulf Coast hurricanes -- is near where it was before the storms hit.

Strong demand suggested by the weekly claims reports has Wall Street looking for payrolls to have grown by 200,000 in the month.

And weekly crude inventories posted a 118,000 barrel rise against an estimated 500,000 drawdown, easing worries about energy-related inflation pressures.

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