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

Bonds reflect world of default and deflation

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Fear of persistent low growth, even deflation, in the United States contributed to the Fed launching another round of quantitative easing (QE2) in November, which will be executed through the purchase of $600 billion in Treasuries throughout 2011. Low growth and high unemployment will likely persist in 2011, and if not improved on could lead to further Fed actions (see “Is the Fed playing with fire?”).

Fed Chairman Ben Bernanke has made it clear that unemployment and low growth drove the decision.

Unemployment has been a major concern throughout the recession. The latest official numbers, released on Dec. 3, put unemployment at 9.8%. Other figures, like those compiled at ShadowStats.com, which includes discouraged workers and part-time workers looking for full-time positions, peg that figure even higher (see “Not adding up”).

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Bernanke said in a “60 Minutes” interview that it will take four to five years before unemployment goes back to pre-recession levels. He says we have regained about 1 million of the 8.5 million jobs lost.

Bernanke has told lawmakers QE2 could create more than 700,000 new jobs over the next two years. By buying Treasuries, the Fed is hoping to make loans cheaper and thus get Americans to spend more, leading to job growth.

Another reason for QE2 was inflation. In August 2010, when rumors of a second round of easing were beginning, debate arose as to whether inflation or deflation would be worse for the economy.

“Inflation comes into play because the Fed is saying they want inflation. They are so concerned about deflation that they are willing to take on inflation,” Kurzatkowski says.

This is ironic in that part of the Fed’s dual mandate is to fight inflation. Bernanke said in the “60 Minutes” piece that the “fear of inflation is overstated.” He added that while the Fed wants to encourage inflation, it will not allow it to rise over 2%, saying it can raise interest rates in 15 minutes if it has to.

Critics say that it is not so easy to stop that inflation train once it gets rolling, and there have been a lot of inflation-inducing policies — easy money, devalued dollar and deficit spending, to name a few — enacted over the last few years.

Analysts advise watching economic data for indicators that the Fed’s program is working. “You want to be looking at this economically. Is the economy picking up steam? Are there jobs being created? As those things happen, the yields will move quickly higher,” Kinker says.

Some analysts are skeptical. While the bond buying may spur inflation, we have to wonder if that will get employers to hire. At this point, a lot of companies have learned to operate at very high efficiencies with fewer employees doing more work than ever before. Now that banks and companies are stable, the dilemma has become, will they keep running efficiently and continue pushing their employees, or will they add jobs to ease their loads?

As to the actual bonds, the Fed is targeting its buying at the mid-range Treasuries. As such, the five- and 10-year notes will be most sensitive to the economy. For now, though, Kurzatkowski sees the five-year finding support at 120 with secondary support at 119. Resistance, he pegs around 121, but says we may see 122 if prices push through the first level. Barrett sees much the same with an expected range of 119 to 121.

In the 10-year Treasury note, Kurzatkowski sees support at 123-16 with resistance around the contract highs of 127-16. Barrett sees a slightly smaller range from 123 to 126.

The 30-year Treasury note probably will not be as affected by the Fed’s buying, but watch inflation for an indication as to where the long bond will go.

Broz points out that the 30-year has been enjoying a nearly 25-year uptrend in about a 20-point channel (see “How long can this last?”) and current prices are in about the middle of that channel. He warns, “If there is a breakout of this channel, it could be very significant (see “Tech talk: every trend must end”).”

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Most analysts forecast a little narrower band for expected support and resistance in the 30-year. Kurzatkowski said 130 is a “stout level” of resistance but only gave the low-120s for support (an area being tested as we go to press). Barrett pegged the 30-year in a range of 124 to 129.

Last year was marked by fears of default and deflation. The EU is taking steps to prevent defaults and the Fed is trying to create inflation. The long-term impact of these programs is still unclear.

Yields have been low for their own “extended period” and, as long as high levels of uncertainty remain, it is likely U.S. Treasuries will remain the safe haven. Kinker adds, “There is very little reason to hold most of these for very long unless you think the economy is going to do poorly over the next couple years.”

Let’s see how long the Fed holds them.

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