Less Reason To Be Bored, But Bored Still

By: Michael Ashton | Thu, Oct 28, 2010
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The bond market continues to worry, while the stock market continues to be bored by the whole lead-in to the election and Fed policy meeting next week. (The equity market traded lower in the morning but ended the day off a scant -0.3%.)

Bond investors are preoccupied with QE2, clearly. The Treasury market suffered a setback overnight on the basis of a Wall Street Journal article entitled "Fed Gears Up for Stimulus," by Jon Hilsenrath. Hilsenrath is supposed by some people to be the current Fed 'mouthpiece' by which market expectations are adjusted while retaining plausible deniability for the Fed. In the article, citing no one (and thus doubly suspect for the specificity of the speculation), Hilsenrath states:

"The central bank is likely to unveil a program of U.S. Treasury bond purchases worth a few hundred billion dollars over several months, a measured approach in contrast to purchases of nearly $2 trillion it unveiled during the financial crisis."

Investors, based on the reaction of the bond market, expect more than "a few hundred billion," although the article did not suggest that amount "over several months" would be the sum total of the operation. Indeed, it is generally supposed that more than $100bln a month would be difficult operationally for the Fed, so such a pace is pretty close to full-throttle for QE2. I suspect that what was being run up the flagpole was the wording of the announcement, and whether the Committee should highlight just the near-term plan or whether it is necessary to allude to continuing purchases in the future. I suspect the answer will be the latter.

The worries about a less-dramatic-than-expected QE2 apparently trumped, for bond investors, the possible renewal (already) of the Greek tragedy. Greece's Finance Minister said today (story here) that tax revenues have been falling short, and so the budget shortfall will be above 15%...quite a bit more than Prime Minister Papandreou suggested it would be as recently as October 7th. Greek bonds got whacked, along with other European bonds. Golly, we thought that the ECB's rescue would buy more than a couple months of peace!

While the Greek news helped the dollar (as did, probably, the speculation of smaller QE2), it didn't boost Treasuries as much as one would have thought. Bonds also seemed indifferent to the weak Durables number. Durables ex-Transportation was -0.8% versus expectations for +0.5%, which means that core Durables actually declined over Q3, and Nondefense Capital Goods Orders ex-Aircraft fell an annualized 5.5% during the quarter. Shipments of nondefense capital goods still rose, so this will not much drag on Q3 GDP, but the outright decline in orders is a bad sign for future quarters and another indication that the post-Lehman bounce has run its course.

In other news, even without QE2 we got an inflation bump: the Metropolitan Transit Authority in NY announced that bridge and tunnel tolls will rise 7.5% on December 30th. This follows increases in train fares several months ago. While stochastic increases in tax rates and fees are not technically inflation (because they are not automatically repeated), they do raise the price level and so are beneficial to those holding indexed bonds.

Today, though, indexed bonds took a beating. The nominal 10y yield rose to 2.71%, but TIPS yields rose more than nominal yields rose, so inflation breakevens and inflation swaps declined 3-5bps. Some of this may be hangover from the 5y TIPS auction, but I suspect most of it is profit-taking in long-TIPS and long-inflation positions from much sweeter levels - taking chips off the table before QE2 especially if Hilsenrath is right and it will be underwhelming.

Fortunately, we are down to a blessed few days before we will get resolution to the two major uncertainties facing investors: the election and the Fed meeting. Not surprisingly, implied volatilities have risen for the last couple of days, and today the VIX peeked over 22 after starting the week at 18.78. After these two events pass, I would expect to see the VIX decline - unless there is a major market-affecting surprise from one of those two events.

On Thursday the only data is Initial Claims (Consensus: 455k vs 452k last week). There is not much to say about that. There is also the last auction of government duration prior to the big events, as the Treasury looks to unload $29bln of 7y notes. Even as investors are cutting positions, I would think the auction goes well simply because the issue is some 25bps cheaper than it was a couple of weeks ago. But I would think that dealers presently will be fairly interested in distributing the risk quickly, and a good auction may be met with selling.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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