Spain, Argentina and Emerging Markets

Spain managed to place its Bill auctions today and though the paid far more than last time, at least people bought the debt. Thursday will be another test as Spain tries to sell 2 and 10 year notes but at least it is only 2.5 billion Euros so the market does appear somewhat complacent. Equities and credit both rallied today even as US economic data was less than rosy, with industrial production missing expectations and signalling a slowdown in the pace of economic growth towards the end of the first quarter. US Treasuries sold off but only by a few bps as the Federal Reserve continued with its buy backs. Today the Fed bought $1.8 billion of off the run 30 year bonds while tomorrow the plan is for them to buy back as much as $5 billion of 10 year notes. This probably generated some frustration from those shorting Treasuries as such a strong rally in equities that we had today would normally produce a big sell off in rates.

Argentina bonds were under continued pressure as investors both locally and internationally sold positions in reaction to the government's proposal to seize control of 51% of oil company YPF and effectively nationalize it. Argentina corporate bonds also suffered as the government proclaimed that all companies in Argentina are Argentine companies, implying there could be other nationalization targets in the future. It appears that President Cristina Kirchner may take a few pages from Venezuelan President Hugo Chavez's playbook and nationalize everything in sight. The fact is that Argentina has always been viewed as an emerging market and yields have repriced to the point that some investors may try to bottom fish a bit. Argentina yields have soared past Venezuelan bond yields and past some of the weakest rated US credits. Cristina has given us shock and awe but those who know the country may say that they are surprised that this event didn't happen sooner. US rates are extraordinarily low and expected to stay that way for a few more years so investors looking for a place to earn a better return will still seek out the emerging markets and events in Argentina will not scare them away.

April 16, 2012 US Fixed Income Commentary

If Treasuries were rallying due to a flight to quality, people wouldn’t be buying stocks so the more likely driver would be speculation about another round of quantitative easing. The possibility of continued mortgage backed securities buy backs to support the US housing market seems credible but it would take a significant deterioration in US economic fundamentals to trigger more Treasury buy backs. Tomorrow we get housing starts, building permits and industrial production data for March which should be important since Federal Reserve officials have signaled that their policies will be data dependent. We also get $2 billion of Fed buy backs in the long end followed by $5 billion of 10 year buy backs on Wednesday and another $2 billion of 10-20 year bonds on Thursday so that should limit the damage should we get stronger than expected data. Market focus will also be centered on the Spanish and Italian debt saga. As Spanish 10 year yields broke above 6% today, credit markets traded heavy but equities showed strength so possibly that was QE speculation. Spain will attempt more bond auctions on Thursday and without any ECB support markets may hesitate. Despite Treasuries rallying throughout the day, by the close they moved back to unchanged. High grade credit spreads were mixed, with banks a couple tighter, telecom a couple wider and basic materials unchanged.

Lat Am low beta sovereign bonds were generally better bid though prices were locked in a holding pattern. Chile rallied another ¼ point, in line with Treasuries. Venezuela attempted an early rally, with CDS tightening 10 bps and bond prices rising ½ point in the morning, but then profit taking pushed levels back to only slightly better on the day. The question of whether a YPF nationalization was priced into Argentine sovereign levels was answered today as bonds fell almost 3 points and CDS spreads widened nearly 50 bps after President Kirchner proposed a seizure of 51% of the company.

The inevitable correction

We all knew that Europe's financial problems couldn't be solved quickly but needed a reminder in order to see markets impacted, so Spanish as well as Italian bond yields creeping  back up again provided the trigger. Combine that with a lackluster US jobs report and you have Treasuries back within the well worn range established months ago of 1.9-2.06%, as 10 year notes closed at 2.05% on Good Friday in an abbreviated trading session. Gold broke through key technical support levels and you have equities also in correction mode. The US economy may be in a 2-2.5% growth environment and with inflation running 2-3% that would imply 10 year Treasury rates at around 3% or higher, but you have the overwhelming fear of a return of the European sovereign debt crisis hanging over the market in the short run. A correction in equities and commodities should be expected as well since you've had extraordinarily high returns achieved in a relatively short span of time that has been mostly driven by the Federal Reserve keeping interest rates extraordinarily low through their quantitative easing program that is due to end in June. The Fed provided clear signals that no QE3 will be forthcoming unless a dramatic change in the US economic climate occurs so there is not much to look forward to in the short run and the path of least resistance for equities and commodities appears to be down. Spain's fiscal deficit is failing to meet targets established by European Union and IMF leaders and Italy has an astronomically high debt/GDP level. Historically, markets didn't seem to mind Italy's massive debt because its fiscal deficit/GDP was within reason but with the latest austerity measures, their fiscal deficit may actually get worse before it gets better. Investors seem less willing lately to fund those deficits and LTRO money appears to be running out.. The trillion Euros of 1% 3 year loans (LTROs) provided by the ECB to European banks had eased concerns about failed sovereign debt auctions as banks were now enabled to buy the debt and make some attractive carry but it appears that investors are becoming more demanding now and auctions are clearing at higher and higher yield levels. LTROs were meant to also fund the banks so they wouldn't have to access the capital markets over the next few years, not just to buy sovereign debt. Add to that the fact that German economic growth is faltering, previously thought to be the engine that might pull the other European nations out of recession, and you have a self-reinforcing situation of worsening fiscal deficits that will result in worsening debt levels. In the US, we learned a long time ago that the best way out of a heavy debt burden was to stimulate economic growth to generate higher tax revenue so austerity is liable to drive debt levels in the wrong direction.

US Treasuries, Another Fork in the Road

US interest rates took a turn higher yesterday after falling most of last week and may continue climbing higher on Monday with fears of stronger US economic data reports in the days ahead. The 10 year note may very well hit 3% by the end of June unless some unforeseen and unlikely risk squall hits our shores in the months ahead. Yields have been trending higher since last month as the monthly US Treasury refunding buried traders in bonds just as anxiety over the European debt crisis was waning and US economic data had been mostly signalling a stronger than expected economic recovery. Unseasonably warm weather during winter has likely played havoc with US economic data that is almost all seasonally adjusted, possibly giving the appearance that the economic recovery is more brisk than common sense might suggest from those of us who actually live here. More importantly though, most would agree that 10 year notes do not belong and probably never did belong at 2% or lower and that unnatural state was, and still is caused by the Federal Reserve's "Operation Twist" program whereby the government is buying back Treasuries with maturities 7 years and longer. That program is ending in June, so as long as market sentiment remains "risk on", Treasury yields are susceptible to moving higher, especially around big bouts of supply like we will see in the second week of every month. Inflation is running at least 2% so after taxes US Treasuries provide negative real yields and the only justification for holding them would be risk aversion. Europe's successful implementation of the LTROs, lending European banks 1 trillion Euros of 3 year money at 1%, as well as the successful restructuring of Greek debt substantially reduced people's risk aversion for the moment. US equities have had their best 1st quarter return on record and high yield returns continued to reward investors for taking credit risk. The relatively low yielding Treasury has been one of the best returning asset classes of the past 20 years but is likely to become a drag on investor portfolio returns in the coming years so get out of the way. We are often reminded that the Federal Reserve Chairman is a student of the Great Depression, and he takes every opportunity to make dire pronouncements about our economy and fiscal state to justify extremely accommodating monetary policy. One hopes he has studied equally as much the stagflation of the 70s as well as how difficult and how long it took to reduce inflation in the US to current levels as our economy has an inherent inflation bias built into it already. When the Fed does eventually decide to reign in the money supply, people will be reminded of just how volatile short maturity interest rates can be but that is still at least a year away. What is more imminent is the threat of rising long term interest rates as the US and European economies progress toward a more normalized state from the state of emergency that currently exists.

Nothing Goes Up in a Straight Line

Regardless of how the monthly US labor report came out, people were primed to sell Treasuries but finally this afternoon we stabilized now that rates are back to levels not seen since early last year. 3, 10 and 30 year bond auctions are looming later this week but hopefully we have priced in a sufficient concession to bring in buyers.. While the US economy appears to be growing at healthier pace, housing is not likely to benefit from higher interest rates and structural unemployment continues to be a challenge so there seem to be some built in restraints to excessive growth.  It is a somewhat goldilocks environment in which corporate bonds can thrive as the economy is strong enough to support improving fundamentals while not too strong as to provoke a more painful spike in interest rates. Credit spreads are in fact tightening for that very reason.

How Do We Make Money This Year?

I am not a financial advisor so I am not giving advice. It is my opinion, and we all have those, that the way to make money this year in bonds is generally to trade from the long side by owning ample amounts of credit spread product like high yield and emerging market funds. It will be somewhat of a trading range year, where you can make a little extra money buying on dips, but generally it will pay to be long as you are likely to earn your coupon so he with the highest coupon will win. It won't be the best or the worst year ever for bonds and you will make most of your money on interest rather than capital appreciation. Treasury yields may trend a bit higher by the end of the year to build in a 2% inflation rate that may result from a stronger economy and lots of policy stimulus. Stocks and bonds have presciently anticipated what may come as a surprise to many of us, that the US economy is recovering faster and stronger than expected. The Federal Reserve may get its wish of 2% inflation before long but of course it would be arrogant of them to think they could so finely tune the economy to reign inflation in at just the right time. They will raise interest rates and raise reserve requirements when the time comes in order to keep inflation in check, but that is likely to be a 2012 event and by that time they will widely be perceived as "behind the curve". For now, the economy will expand in fits and starts. October and November 2010 were strong months while December less so. January is shaping up pretty good, with consumers spending and manufacturers happy to ramp up production. The labor market is key to a strong and sustainable expansion so tomorrow's jobs report is critical to market tone. The 10 year Treasury note has been pushing up on support levels not seen since last May and a strong report may push us into a new range of 3.5-4%. If that happens, corporate bonds may struggle for a few weeks as they compete with higher Treasury rates which will lead to lower prices and provide an opportunity to add high yield bonds to your portfolio. If you already own as much of them as you will ever care to, it is best to sit tight as your high coupon will offset capital loss from prices falling and ultimately your returns are likely to close the year in positve territory. At least that is my view.

A Bump in the Road

Argentina bonds were one of the best performing investments of 2010, returning 38%, so it was inevitable that at some point investors would take profits and that is exactly what they've been doing these past few days. Bonds today were generally down about 1 1/2 points. Venezuela bonds also came under attack, dropping about 3/4 point on top of yesterday's losses which were partially the result of news that Chavez wanted BBVA's Provincial banking unit out of the country. Traders sold Brazil sovereign bonds too, partly due to the turn in Street psychology but also due to the news that Banco Panamericano would need a larger bailout than previously announced. Banco Panamericano bonds fell sharply today, much like they did a month ago when the news first hit that the bank was severely under capitalized due to accounting irregularities, but the rest of the high yield Brazil bank bond sector snapped back. El Salvador 30 year bonds just issued a few days ago that traded as high as $100.85, made their way back to par. Global equities markets were fairly stable today and commodities prices were mixed, so it was a bit unexpected for EM to sell off as it did. Egypt and Lebanon were engulfed in political protests, so after the uprising in Tunisia people were put on alert. Soybean farmers in Argentina took to the Streets in protest and that is country's largest export. US Treasuries sold off at least part of the day and then rallied back slightly after a decent 7 year note auction. After the Federal Reserve communicated yesterday after its 2 day FOMC meeting that it would continue with its quantitative easing measures, people ended up selling Treasuries as they were concerned about inflation creeping up in the US as it has in the UK where quantitative easing measures have also been actively employed. Economic data was a little disappointing, with durable goods and weekly jobless claims missing the mark, but not enough to derail the prevailing sentiment of an economy on the mend. With the economy growing at a measured pace, inflation still at bay, rates locked into a range and people still enamored with the emerging markets, today's sell off is not likely to last long.