From the January 01, 2011 issue of Futures Magazine • Subscribe!

Bonds reflect world of default and deflation

A year ago we wrote, “The global credit crisis kept interest rates near zero in 2009, and the Federal Reserve is determined to keep rates extremely low for the foreseeable future,” (see “Interest rate policy: Under pressure,” January 2010). That lead worked to describe the financial situation of the country then, and it largely still works today.

While the early months of 2010 were painted with a rosy picture of an economy that was beginning to recover, that picture was suddenly marred as the Fed’s initial round of quantitative easing came to an end and sovereign debt problems arose in Europe. The world was reminded that there was much work to be done to unwind the mess that led to the credit crisis of 2008. Further, around the same time the recession officially was declared over since summer 2009, rumors began that the Fed was leaning toward another round of quantitative easing (QE2).

Jim Barrett, senior market strategist at Lind Waldock, summarized 2010 nicely. “Bonds were in a little bit of a pickle in the beginning of the year and around April bottomed out around 114. [By] mid-April, [Treasury] notes and bonds started turning up,” he says. “The European problems we are seeing now popped up and the ‘flash crash’ really started making bonds look good. All summer we cruised up as the [talk of a] double-dip [recession] started becoming a banner event. The double-dip fears were enough to influence Bernanke and crew,” he says.

Many of these stories that shook, and in some places bolstered, global economies will continue to send reverberations in 2011. Of those factors that will continue to move markets, fears of default and deflation top the list.

Questions about the solvency of some European nations still remain and will likely continue to play a role in 2011. In 2010 we saw two of the five “PIIGS” countries (Portugal, Ireland, Italy, Greece and Spain) face major problems with riots resulting in Greece, and Ireland accepting an €85 billion bailout package.

Even with bailouts, Greece and Ireland still are being closely watched. “Ireland really didn’t want to take the IMF [International Monetary Fund ] money and it really is just a Band-Aid on a bigger wound,” says Rob Kurzatkowski, senior commodity analyst at optionsXpress. “They are paying upwards of 6% on their current debt and it is unlikely their economy will grow at that pace. So, they will have to keep issuing more debt to finance the debt they already have.”

This has left many speculating about what we can see next year from the PIIGS. “I can see a few more countries like Portugal and Spain having trouble, and I can see the European Union (EU) propping them up. U.S. bonds would be the safe haven bid as that happens,” says Jack Broz, founder of TradeBondFutures.com. “Germany and Britain are too strong for the whole thing to crumble.”

European turmoil was positive for U.S. bond prices (see “Quick turnaround”). The five-year Treasury note had dipped below the year’s opening price of 114 when news of problems in Greece started to surface. As those problems escalated, U.S. Treasuries soaked up the risk and started a sharp rally until the Fed’s official QE2 announcement.

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Overseas economies turned to U.S. bonds in 2010, and some analysts expect the trend to continue into 2011, noting the fourth quarter pullback could have been worse if not for the European problems. “There are concerns that Portugal and Spain will be the next to reach out for aid. Also, Italy is racking up considerable debt. That is making the U.S. bonds stronger by default,” Kurzatkowski says. “We probably would see more of a pullback, especially in the 30-year bond, if it wasn’t for concerns that Europe may have stretched itself a little too thin.”

Even questions of whether the EU will let sovereign debts fail are being discussed. Perhaps it may not be so bad for the EU to allow a member to go into bankruptcy. We saw this in the United States with GM’s bankruptcy, and that actually gave the company a fresh start.

Should that happen, though, serious risk to the system could occur. “If things were to rapidly deteriorate over there, there could be a lot of risk bid. In the past, when there were the major overseas events, we weren’t sitting at 2% [yields in the]10-year note,” says Kurt Kinker, chief market analyst at Mirus Futures.

Even at current yields (see “Riding the curve”), we could see further tightening because of European default fears. “We’re going to see yields shrink. If the European crisis spills over into the equities and we see a large correction in equity prices, we may see long bonds rise a smaller degree than the five- and 10-year notes. They may put some pressure on yields as they shrink,” Kurzatkowski says.

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He also says Eurodollars will gauge many of the shorter-term notes.

Although the recent strength of the dollar has been very supportive of Eurodollar futures, Kurzatkowski cautions, “Watch currencies. The corporate bond market could have an impact. If there is some general panic or concern about the economy, then we may see Eurodollars fall back in relation to notes. If things stabilize, Eurodollars will probably hold up fairly well because they are dollar based.”

For Eurodollar levels, he pegs resistance at 9975, saying the Fed would basically have to go negative on interest rates to cross that level. Support is found around 9950, and if that is broken then at 9925.

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