Bond Traders Are Doubters, Lemmings or Sissies: Caroline Baum

Commentary by Caroline Baum

Sept. 28 (Bloomberg) -- I’ve been watching the bond market recently, but frankly there hasn’t been much to see. Treasury yields ebb and flow in the narrowest of ranges, with an occasional hiccup to break the monotony, seemingly immune to economic news or what’s going on in other markets.

The nonreaction in short-term Treasury bills and notes is understandable: They take their marching orders from the Federal Reserve. While the Fed upgraded its assessment of economic activity from “is leveling out” (Aug. 12 post-meeting statement) to “has picked up” (Sept. 23 statement), policy makers continue to assure us that the soothing balm of a federal funds rate close to 0 will be with us “an extended period.”

Where are those gunslingers of yesteryear, ready at a moment’s notice to assert themselves in the marketplace, challenge the Fed on its easy-money stance and punish the federal government for its profligate spending? Why are bond traders so blasé when short-term interest rates have nowhere to go but up, the U.S. economy is recovering, the Fed is ending its purchases of Treasury notes and bonds, the Treasury is continuing to sell notes and bonds, the dollar is sinking, and foreign central banks are making noises about the out-of- control U.S. budget deficit?

“I’ve already lost a fair amount of money trying to answer that question,” says Paul DeRosa, a partner at Mt. Lucas Management Corp. in New York.

Here are some possible answers, in no particular order of importance:

1. What Recovery?

Most economists, including Fed chief Ben Bernanke, say the recession that started in December 2007 has ended. The median forecast for third-quarter gross domestic product growth is 2.9 percent, according to a Bloomberg News survey of 61 economists conducted the first week of September.

After declines in real GDP for five of the last six quarters, a return to growth would normally create some mild dyspepsia in the bond market, even though inflation, that scourge of fixed-income securities, trails the economic cycle.

It would -- unless investors believe third-quarter growth is manufactured. “Cash for Clunkers” may have boosted auto sales in late July and in August, but Edmunds.com, an auto information Web site, expects September auto sales of 9.3 million, the lowest since April. That seasonally adjusted annual rate represents a 23 percent decline from August and a 41 percent drop from a year earlier.

The same holds true for the first-time home buyers’ tax credit of up to $8,000, which expires Dec. 1. Both of these programs have pulled sales forward. Bond investors may wonder if there’s more where these came from.

2. Dow 6,547

With Dow 10,000 within reach, some equity analysts are warning that the stock market is overvalued. Others are pointing to the historical pattern of big rallies followed by big sell- offs.

The Dow Jones Industrial Average rose 50 percent from its March 9 low to a Sept. 22 high. A six-month rally of that magnitude has happened only six times in the last 100 years, according to the Wall Street Journal.

If things are as rosy as implied by stock prices, what are bond yields doing where they are?

As a former bond trader put it to me, those 3.5 percent 10- year notes will look good if the Dow retests 6,547 after the government has thrown the kitchen sink at the economy.

Oh, and that’s 3.5 percent en route to 2 percent.

3. Bank Backing

By the end of October, the Fed will have purchased $300 billion of Treasury notes and bonds, or 29 percent of the net Treasury issuance of about $1 trillion during that period, according to Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey.

At the same time, foreign central banks continue to recycle their U.S. dollars into Treasuries.

Whether it’s a lack of loan demand or a lack of appetite for lending to anyone but the most creditworthy borrowers, commercial banks are buying U.S. government securities.

Government borrowing may be soaring, but it’s being offset by reduced demand from non-financial corporations. The government can’t crowd anyone out if no one is looking to get in.

4. Cost of Conviction

Selling 10-year notes short is an expensive proposition if the price doesn’t fall, according to DeRosa.

The seller of the securities has to borrow them in the repo market and earns a pittance on his collateralized loan. In addition, he owes the coupon interest to the owner of the securities.

Right now, it costs 4 percent per year to short 10-year Treasury notes, DeRosa says. “You have to be a true believer to short and hold.”

5. Least Worst Scenario

After years of dabbling in credit derivatives that almost took down the financial system, Wall Street is still gun-shy.

Yes, appetites for risk have increased, and credit spreads have narrowed -- in some cases by hundreds of basis points. But return of capital still is a higher priority than return on capital, a view that became apparent when Treasury bill yields went negative late last year.

In short, no one ever got fired for owning Treasuries.