In what is beginning to sound like a broken record, the global credit crisis kept interest rates at historically low levels throughout 2011 and the Federal Reserve is determined to keep rates extremely low for the foreseeable future. In other words, not a lot has improved in the global economy over the last two years.
Although 2011 began with hopes that the Fed’s second round of quantitative easing (QE2) would lead to a sustainable recovery in the United States, the reemergence of sovereign debt problems in Europe quickly dashed any optimism that was beginning to take root.
Additionally, the summer of 2011 saw the United States mired in political gridlock over the nation’s budget deficit, which resulted in Standard & Poor’s dropping the United States’ credit rating to AA+ and Moody’s and Fitch placing the country on negative outlook (see "Who’d a thought?" below).
As we enter 2012, although we recently have seen improving indicators about the health of the U.S. economy, none of the issues that plagued 2011 have been resolved and most are in an even more egregious state. Looking ahead, analysts we spoke with expect the European sovereign debt crisis, the Fed and the U.S. budget to continue to drive the U.S. Treasury markets.
Old World problems
To many analysts, the European sovereign debt crisis arguably is the number one factor driving the bond market. "It seems like every time we don’t get any bad news for a few days, the bond market starts to tick back down and yields start to rise in the 30- and 10-year. Then all of a sudden we get a headline or rumor [about Europe] and U.S. bonds spike back up," says Travis Rodock, senior futures analyst at eFutures.
Even though the issue first came to light nearly two years ago, the situation only has been exacerbated with Italian and Spanish debts closing in on 7% yields, a rate many analysts say is unsustainable. Additionally, credit rating agencies have made various downgrades on European debt and many still are on credit watch negative (see "Making the grade," below).
With few truly legitimate solutions having been presented, Rich Asplund, analyst at R.J. O’Brien’s Market Research & Trading, says the European crisis really is a wild card going into 2012. "It’s difficult to say if it might blow up into an all-out crisis, and I would put the odds of that happening at around 20%," he says. "My view is that it won’t get all that much worse than it is right now; we’ll be able to muddle through."
Kathy Jones, vice president of fixed income strategies at Schwab Center for Financial Research, says the trouble with the European debt problems is that the solutions are all political rather than financial, and the result likely will be a prolonged period of slow growth. "You have to be a political junkie to understand all the ins and outs. My view is that the most likely long-term outcome is a prolonged period of austerity and slow growth in southern Europe, and measures like we’re seeing recently from northern Europe to try and provide liquidity while that process works out," she says.
The result of the whole situation has been investors scrambling to find a safe haven to stash their money while the situation works itself out (see "Good as gold?" below). "There’s not a lot of places for people to go with their money if they’re looking for safe-haven assets right now," Rodock says. "It used to be that you had U.S. dollars, Treasuries or gold. Gold has started trading like a risk asset, so now you’re only really left with two choices: Treasuries or U.S. dollars. Although a lot of people say the U.S. isn’t in a great position either, at this point we’re the least dirty shirt in the hamper."
Rodock expects Treasuries to be well-supported going into next year. He sees the 30-year March T-bond staying in the 140-145 range with any new crisis out of Europe or China pushing it through 145 toward 150. He sees the same situation in the 10-year T-note with the March contract staying in a trading range of 129-131. He also expects Eurodollars to remain in a trading range until the Fed raises rates, something he doesn’t expect until at least the third quarter of 2012. In the March contract, Rodock sees stiff resistance around 99.56 with support down at 99.15.
On the home front, the Federal Reserve took some uncertainty out of the market earlier in 2011 when it gave some clarity to what it meant by "exceptionally low rates for an extended period of time." The Fed basically vowed to keep its Fed Funds rate at the current 0-0.25% through mid-2013.
Larry McDonald, senior director of credit sales and trading at Newedge, is confident the Fed will stand by this projection. "This new language the Fed is using in terms of visibility is a new tool and they don’t want to hurt the integrity of that tool. When you say to Wall Street that you’re going to keep rates at a certain point, if you hold to your word, then it creates a new tool of liquidity," he says.
While many in the financial world worry about potential inflation from this long-term accommodative stance, the Fed appears to be focused on the "full employment" part of its dual mandate. And employment remains at crisis levels while inflation expectations have leveled off.
Nonfarm payrolls have continued to grow modestly in the second half of 2011. In the November report, released on Dec. 2, the U.S. economy added 120,000 jobs and unemployment had ticked down to 8.6%, a decrease of 0.4% from the previous month. The surprisingly large drop in the rate did not match the more modest jobs numbers and most likely is because of long-time unemployed falling out of the survey.
Dave Toth, director of technical research at R.J. O’Brien’s Market Research & Trading, says employment is at the heart of the crisis. "You can pump as much money into the system as you want, but if people aren’t out there buying and chasing goods because they don’t have jobs or they have to worry about their jobs, then there’s not going to be any sustained upward pressure on rates, stock prices or economic growth," he says.
Rodock says the United States won’t see sustained recovery until the labor situation turns around. "The Fed realizes we’re not seeing a lot of demand for borrowing because of [high unemployment]. People who don’t have jobs aren’t going to take out a loan for a new mortgage or car, they’re going to pile their money into cash and save it," he says. "If we start getting jobs back, liquidity start to free itself up and more people are willing to borrow. That itself will get the market chugging along." At this point, though, Rodock believes the Fed is doing everything in its power to stimulate jobs growth.
Although a number of fears last year surrounded a double-dip recession and the possibility that the United States may enter a period of deflation, that never materialized as the Fed finished QE2 and implemented "Operation Twist," in which it currently is selling short-dated securities to purchase ones further out in the curve.
Looking to 2012, most analysts don’t expect inflation to pick up much. "We’re not looking for a big pick-up in inflation, in fact it may drift a little lower from here," Jones says. "We’ve seen quite a few things come off their highs."
Based on those inflation expectations, Jones is expecting 10-year notes and 30-year bonds to remain in a trading range through the first part of 2012. Although she doesn’t forecast prices, she says the 10-year T-note yield will stay around 2%, plus or minus 20 basis points. The 30-year T-bond will stay in the 3% to 3.4% range.
Breaking the budget
The U.S. fiscal situation likely will impact interest rates. U.S. debt already has been downgraded by one credit rating agency and the other two placed it on negative outlook because of its deficit and political gridlock.
However, after S&P downgraded the United States to AA+ this summer, bonds rallied dismissively of the downgrade. Jones says future ratings moves probably also would have little impact on yield. "Investors decide what the yield will be, not the rating agency," she says. "It wouldn’t be much of a surprise [if Moody’s or Fitch] downgrade us next year, but I also don’t think that would have much of a market impact."
McDonald says Moody’s may decide to act sooner based on the political gridlock already gripping Washington, but agrees that the impact probably would be negligible. "Today, it all comes down to two things. The flight to quality rallies overpower everything. When Lehman failed, Treasuries rallied. You have that flight to quality rally that is driving things," he says. "The other thing is the [depth] of the U.S. Treasury market. A lot of investors don’t understand how global institutions need the [depth] of the U.S. Treasury market. If Europe didn’t exist and Moody’s downgraded the U.S., then rates would go up 20-25 pips. But, because Europe is there, it trumps anything that comes out."
Asplund calls the U.S. fiscal situation a long-term bearish factor for bonds and T-note prices and expects us to muddle through the next year, at least through the 2012 election. "The markets already know where we’re at, they already know not much is going to happen. The ‘Super Committee’ failed and we still will get automatic spending cuts in 2013," he says.
At the heart of the uncertainty is the political gridlock in the United States. "The question on the budget really comes down to whether there will be continued political gridlock after the 2012 election or whether one side will sweep and be able to clean things up," Asplund says. "We really need one party to sweep both houses and the presidency to get the budget situation cleared up. That’s not likely to happen."
If it doesn’t, Asplund says yields and credit risk could spike upward. He doesn’t expect credit rating agencies to make any adjustments until after the election.
Looking primarily at the 10-year T-note, Toth says 2.08% yield will be an inflection point that may signal intermediate-term moves. He is bearish the March contract and sees support around 126-07, or a yield of 2.40%. "If there’s something much more bearish, price will break below 126-07. You can’t ignore the possibility of higher rates next year, but technically, you have to break that 2.40% yield to look more objectively at that," he says.
Concerning Eurodollars, Toth is cautiously bullish and says weakness below at least 99.21 and preferably 99.12 is required to threaten this call through March.
Although a number of global economic problems persist, Chris Brighton, global head of rates at Newedge, says things may begin to turn around next year. "I’m quite optimistic that we’ve seen some low yields. Those yields were put in around Nov. 23 and Nov. 29. I expect the curve to steepen from here, especially in the back end."
Looking ahead, Brighton expects the March five-year note to find support at 118-24 and resistance at 123-16. In the 10-year, support is at 124-29 and resistance is at 131-02. In 30-year bonds, he sees support at 135-00 and resistance at 149-16. In Eurodollars, Brighton expects the Fed to stick to its projections of low rates through 2013. In March Eurodollars, he sees support at 98.775 and resistance at 99.50. He projects those levels out to June 2013.
Although much of this analysis may sound familiar, with the same problems plaguing the economy, there are some bright spots and with 2012 being an election year, you never can be sure how the markets will react.