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.
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.
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.
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”).
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”).”
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.