Whether 2010 will be a year when the economic recovery begins to take root could depend on what happens in the Treasury complex and the outlook for interest rates. The global economic crisis kept interest rates frozen near zero throughout 2009. In a November speech before the Economic Club of New York, Federal Reserve Chairman Ben Bernanke reiterated the Fed’s stance that economic conditions would warrant low levels of the Fed funds rate “for an extended period.” The Fed’s actions likely will weigh on the dollar and the economy at large in 2010.
Analysts expect Treasury yields, which are relatively low, to climb a bit in 2010. “I can’t imagine [Treasury yields] moving much lower. Until the Federal Reserve implements policy action, these rates will be reflective of supply and demand for safe assets,” says Mike Kimbarovsky, principal, Advocate Asset Management. “[Three-month Libor] would be the first to react to any uncertainty or volatility [in the market]. It will maintain a low level until there’s uncertainty, and then it’ll spike.”
Kim Rupert, managing director for fixed income at Action Economics, expects the 30-year to hold stable until the middle of 2010, then to climb 30 to 50 basis points by the end of the year. She expects the 10-year yield to hit 3.75% by the middle of next year and rise to 4% by the end. “In early 2010, we have the five-year at about 2.25% and climbing to just over 3% by the end of the year. The two-year, we’ve got climbing to 1% early next year and hitting 2.25% by year end. Three-month Libor will stay at 25 basis points into the middle of next year and maybe rise to 1% by the end of the year,” she adds (see “Yielding little” ).
Carley Garner, analyst and trader at DeCarley Trading, expects the 10-year note futures to trade in the mid-120s in 2010 (see “Talking ten,” page 25), putting the yield at 2.5%. “On the 30-year bond, we could see the low-130s by some point in the first quarter. Two-year notes don’t have a lot of room to move on the upside. I don’t expect the yield to get above 1% until the second quarter of 2010,” she says. Richard Regan, founder of Protradingcourse.com, expects to see all Treasury products rally with yields dropping significantly though the first half of 2010.
“The bond market is far smarter than the Fed,” says Dave Floyd, head of FX research and trading at Aspen Trading Group. “The people who play in the bond market are far more sensitive to what’s going on economically. The bond market’s a much better barometer for what’s coming in terms of interest rates than Fed forecasts.”
But exactly when the Fed will raise interest rates seems difficult to predict. Some say it will happen in mid to late 2010, some say not until 2011. The Fed fund futures traded at the Chicago Board of Trade show virtually no movement until the second half of 2010 (see “Traders expect no action,” page 26). Kimbarovsky expects the Fed to continue to withdraw credit facilities rather than raise the Fed funds rate. “Before [the Fed does] anything on the interest rate side [they’ll] withdraw some of the credit facilities they’ve extended. They decreased the maturity of the discount window from 90 days to 28 days. It’s like a subtle first step to gauge market sentiment without having to raise interest rates,” he says.
Garner doesn’t see rates going up until 2011. “They might adjust rates at the discount window before they touch the Fed funds. Throughout 2009 we’ve seen record-breaking auctions. Simply slowing down the issuance of Treasuries and pulling some of the cash out of the market, stop buying GSEs and long-term Treasuries, will be their first step towards getting rates to a more realistic level,” she says.
“It really depends on how retail sales go into December and January,” Regan says. “[As soon as] the Fed gets an opportunity, they’re going to raise rates, but they can’t do it if retail sales and unemployment still look bad.”
Although other central banks, such as Australia, have begun to raise interest rates, this doesn’t seem to be putting pressure on the United States to follow suit. The one central bank with the most influence over U.S. interest rate policy is the European Central Bank (ECB). Most analysts expect the ECB to raise interest rates before the United States does. “In the U.S., there’s much more political pressure on the Federal Reserve. The policy actions from the Great Depression were abrupt and what the current Administration wants to do is go the other way, which is least abrupt,” Kimbarovsky says. Meanwhile, he expects the UK to delay rate hikes and test the waters by reducing
“More of the ECB is talking about exit strategies than the Fed is right now,” Rupert says.
Garner expects the Fed to coordinate their rate hikes with the central banks of Europe. “If the U.S. makes a step before the European Union, the currency markets are going to go wild and that’s going to throw a wrench in the recovery,” she says.
Regan agrees. “The U.S. should be more concerned about raising rates at the same time as the ECB rather than Australia. I would like to see Europe and the U.S. raise rates at the same time, which would help the dollar,” he says.
Rupert expects Japan to raise rates in late 2010. “The political winds have changed in Japan where the new government is looking to introduce a number of stimulus programs and it’s not obvious that those are going to take hold fully. It’s going to hurt the debt outlook for Japan and that might start to increase interest rates in Japan, which would be a further restraint on growth,” she says.
CHINA MAY FLEX MUSCLES
One country that will have an influence over the interest rate environment is China, the largest owner of U.S. debt, holding more than $798 billion in U.S. Treasuries as of September 2009. Further, interest rates have been held down in large part because of Chinese demand for Treasuries.
Floyd says that by simply buying bonds, China is keeping interest rates low. “At some point, they’re going to get tired of holding our debt, which pays nothing,” he says.
Regan agrees that China is concerned about the sustainability of U.S. fiscal policy. “China is a concerned creditor. They’ve loaned us so much money and they’re worried that we’re spending it recklessly. As far as the dollar goes, China’s going to be careful they make sure they fix their yuan to our dollar so that they don’t price their imports out of the market. As long as China continues to fix their currency to the dollar, it’ll be fine.”
Garner says, “China’s been complaining about the dollar and they’re concerned about the stability of the U.S. economy, yet they continue to show up on auction day and buy Treasuries. Nothing’s going to change in the near term. I would expect China to continue to be a big buyer of Treasuries, at least for the first two quarters of next year, and that should keep a floor
But Rupert says that China has started to see some cracks in its own growth and its central bank may start to pull out some of the stimulus in the system or tighten policy. “There’s some fears that if China actively starts to tame its growth rate, that would spill over into the rest of the world and [slow] the recovery,” she says.
As has been the story throughout 2009, global interest rate policy will weigh on the dollar in 2010. The Fed’s announcement in its November statement that it would keep interest rates low for an extended period weighed further on the dollar.
“Interest rate differentials have played a major component on the dollar’s weakness or the euro’s strength. The Fed [has a] dovish outlook relative to other central banks that are starting to talk exit strategies. With the Fed’s policies lagging other central banks, it looks like the dollar could remain on weaker footing into early or mid-2010,” Rupert says.
Kimbarovsky says we’ve reached a bottom for the dollar that’s supported by the balance of trade and deficit spending across the world. “The trajectory for the dollar is stagnation, or stronger, because you see the inklings of Federal Reserve action to withdraw credit facilities,” he says. “The dollar’s at a weak enough base, which means dollar-linked equity markets are in for a tough next few quarters.”
Floyd is bullish the dollar. “Since markets are forward-looking, markets will begin to discount any type of rate raising policy, but I would not short the dollar at current levels,” he says, adding that the risk-reward is much more in favor of those who want to start building a long position in the dollar over the next year.
Regan says although the dollar is low, the Fed thinks it’s got a lot of room to go before it gets dangerously low. “If we see the S&P get down around 1,000, we’d see a nice rally in the dollar. The two key components that can get the dollar to go up are a sell-off in the stock market and an increase in interest rates.”
Rupert says government policy continues to keep the dollar weak. “Fears that the government won’t be able to rein in its budget deficit are a big negative for the dollar. If the Fed doesn’t start to enunciate an exit strategy or if it continues to lag the other central banks, that will also leave the dollar on heavy footing,” she says.
THE “I” WORD
Inflation as it’s tied to the interest rate picture could be a concern over the next few years. “The economy’s quite fragile, so nobody wants to see higher rates, but at the same time people are concerned that if you keep them too low for too long, you could really stoke [inflation]” over the next three to five years,
Treasury and stock markets are likely to react negatively when interest rates do increase. But the picture’s not all negative, Rupert says. “At first, [the Treasury market] will sell off. It’ll be a knee-jerk reaction lower. It will have a bearish impact initially but eventually will ameliorate some of the fears of the inflation vigilantes,” she says.
Regan expects the stock market to sell off if interest rates go up. “We’ll see stocks rally until interest rates come up. Once the Fed starts increasing rates, you can expect a series of increases and we’ll see the stocks sell off.”
Garner says the equity markets have built in most of the benefits we’re getting from low interest rates. “Most of what the market’s trading off of is that interest rates are incredibly low and the dollar is weak. Bonds are pricing in the worst of everything and stocks are pricing in the best. If the stock market gets wind of the Fed thinking of raising rates in the next year, it’s going to have a downside reaction,” she says.
We’re likely headed for a larger economic recovery in 2010, but that recovery could happen at an incredibly slow pace.
“We’re headed for a [recovery], but it’s going to be tepid at best. It’s going to be reminiscent of the Japanese recovery over the last 15 years. It’s going to be in fits and starts and very slow and uninspiring,” Floyd says.
Garner says we’re stabilizing. “The numbers are improving, but we have so far to go. The jobs numbers are still horrible, unemployment is getting worse. Home sales are picking up, but that’s because of deep discounts, not necessarily because of demand. Government intervention and subsidies are artificially pumping up the economy. A true recovery [won’t] be seen until much later [in 2010].”
Rupert attributes the slow, grudging pace of recovery to the uncertainty surrounding the Obama Administration’s economic policies. “The political backdrop is very negative for the economy and the administration’s continued bashing of the financial sector and the business sector is one of the restraints on the labor market right now — the uncertainty with respect to the administration’s goals.”
The uncertainty of the economic environment means that traders should stay on top of news coming from the Fed and also be flexible in their
“Monitor what’s coming out of Capitol Hill and the Administration. [Be aware] of the Fed outlook and when they start to change their tune to more of an exit strategy and start to suggest risks are more balanced,” Rupert says.
The Fed has been stubbornly sticking to its current policy due to the risks in the market and the weakness of the recovery — if you can even call it that — but the huge debt level gives some measure of control to our creditors who may seek a better return on what is increasingly looking like a risky investment.