Yield Curves

Yield Curves: Yield Curves . . . That's Hot!
by Eric J.  Fry
The Rude Awakening
Wall Street, New York
Tuesday, November 8, 2005

Eric Fry argues why the "sell" recommendation for bonds from Wall Street makes Yield Curves "hot."

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[Joel's Note: What does the word "hot" mean for you? Is it
simply the default adjective for days that reach over 85?
Does it connote an afternoon drive in a brand new
convertible? Or is it something more risqué, something
salacious? Below, Eric argues that yield curves warrant the
use of said adjective. If you're not entirely convinced,
then you simply must read on...

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YIELD CURVES...THAT'S HOT!
By Eric J. Fry

Your New York editor didn't want to write about bonds again
today, but Merrill Lynch made him do it...Actually, Merrill
Lynch, Eaton Vance, Dresdner Kleinwort Wasserstein and CIBC
World Markets all teamed up together to make him do it.
This esteemed cluster of investment banks simultaneously
downgraded bonds.

There is no "buy" signal known to man that is more
compelling than a mass, simultaneous "sell" recommendation
from Wall Street. Knowing this fact, what choice did I have
but to write about bonds again?

As faithful Rude Awakening readers may recall, I began
warming up to the short-end of the yield curve about three
weeks ago. But thus far, the short-end of the yield curve
has not been warming up to me. My affection for 5-year
Treasury notes has gone unrequited. Nevertheless, I
continue to hold a candle for the 5-Year Treasury note. And
now that so many former bond bulls have become bears, bond
buyers might soon be feeling the love...of a bond rally.

"Wall Street's bond bulls are in retreat," Bloomberg news
reports. Leading the retreat is David Rosenberg, the Chief
North American Economist for Merrill Lynch. Rosenberg, a
man whose insights we often admire, recently raised his
year-end prediction for the 10-year Treasury yield to
4.55%, which happens to be precisely what the 10-year
currently yields. Rosenberg's forecast, therefore, would
hardly seem outlandish, except for the fact that he had
been forecasting a year-end yield of 3.80%, as recently as
June.

Meanwhile, over at CIBC, economist Avery Shenfield has
retracted his bullish outlook for the bond market. In
January, Shenfield predicted the year-end yield on the 10-
year would be 4.05%, Now he expects it to be about 4.60%.
Another prominent former bond bull, Eaton Vance economist
Robert MacIntosh, says his year-end yield target for the
10-year is "more of a 4.80%, 4.85% kind of number," up from
the 4.30% kind of number he had expected one month ago.

Rounding out the quartet of retreating bond bulls, Dresdner
Senior Market Economist Kevin Logan has bumped his year-end
yield target on the 10-year from 4.10% to 4.40%.
To be sure, an economist is entitled to change his mind –
both before and after the fact – but when so many Wall
Street bond bulls become bond bears, every seasoned,
contrarian investor must consider taking the other side of
the trade...just like the commercial futures traders have
been doing.

Yield Curves: The Next 5-Year Rally

The "Commercials," often considered the "smart money," have
accumulated their largest net-long position in 5-year
Treasury-note futures since early August. Coincidentally,
or not, the 5-year rallied sharply throughout the month of
August. During this mid-summer rally, the 5-year yield
dropped from 4.28% to 3.82%. We would expect the NEXT 5-
year rally, if it occurs, to produce much larger, and much
more enduring, gains than the August rally. Indeed, we
think there's a good chance that 5-year yields are close to
an important peak.

As I wrote in the October 21st edition of the Rude
Awakening ("Buy Treasuries...For a Trade"), "I love the 5-
year Treasury right now...I think you could make 15% on
this trade in one year or less, with very little
risk...Today's buyer of a 5-year Treasury yielding 4.30%
would do very nicely if yields dipped back below 3.70%, the
level at which the 5-year traded last June."

If a medium-risk 15% return fails to titillate you, dear
investor, high-risk variations of this trade might be more
to your liking. You could, for example, buy options on T-
note futures or options on one of the ETFs that owns
Treasurys. Buyers of long-dated options on a Treasury-bond
ETF might well triple their money between now and next
March...or lose it all.

The obvious risk, of course, is that the yields will not
fall, but will continue their recent ascent in step with
rising inflation. In which case, the buyer of Treasury
securities would fare poorly. The leveraged buyer would
fare even worse.

So far, the bullish scenario has not (yet) come to pass.
Instead, the unsanctioned (by me) bearish scenario
continues to play out. The price of the 5-year has dipped
one full point since our October 21st column, pushing its
yield up to 4.47% from 4.26%. Hardly a disaster, but
disconcerting just the same. Perhaps the market has merely
provided a better entry point, perhaps not.

Yield Curves: A Voluptuous 4.5% Yield

Whatever the case, we remained captivated by this trade.
The 5-year may be a bad bet, but we just can't take our
eyes off of her. There she stands with her voluptuous 4.5%
yield amidst an economy that looks uglier by the day.

Home sales are slowing and auto sales are plummeting, just
to mention two indicators of economic health...and yet the
Fed continues to raise rates. At some point, the economy
should visibly slowdown, if not pass out completely.

"Raising short-term rates may seem necessary in light of
recent nose-bleed inflation readings," we remarked in our
October column, "But raising rates seems utterly
unnecessary, if not downright suicidal, in an economy that
is leveraged to the gills, lacks savings and relies upon
inflating assets for its daily bread."

Consumer spending of every sort is plummeting, largely
because the cost of debt is rising.

The Fed's rate hikes, says Bill Gross, the legendary bond
fund manager on the West Coast, "are starting to
bite"...which, from the consumer's perspective, is starting
to really suck. The rising costs of satisfying upwardly-
adjusting debt burdens has forced many consumers into a
downwardly-adjusting mode.

Because, as Gross observes, rising rates are starting to
bite, the current rate-hike cycle may be drawing to a
close. Usually, that's an opportune time to wade into the
bond market.

"It is certainly instructive to note," says Gross, "that
over six tightening cycles since 1983, the average Fed
Funds increase has been 250 basis points and those
increases have taken an average of 12 months time to
unfold...[which] would place this cyclical tightening in
the '8th inning,' to use Dallas Fed President Richard
Fisher's terminology with 4 ¼% and November/December 2005
marking the historic average levels of extent and time...By
the time the 10-year and 2-year Treasuries reach parity, as
is almost the case now, the economy is typically slowing
and the Fed is at or near the end of its tightening cycle."

As of yesterday's close, the 10-year yielded 4.56%, just 15
little basis points more than the 2-year yield of 4.41%.

Gross also notes that 5-year yields have been rising for
more than two years – a phenomenon that usually signals a
peak in interest rates.

"Typically an economic slowdown occurs 18 months after the
beginning of an upward move in 5-year rates, and this cycle
appears to be no exception, with industrial production and
service-related indicators having peaked nearly a year ago.
The current upward cycle is now 27 months in duration and
230 basis points in magnitude, enough by historical
standards to slow an economy or even produce a mild
recession, given increased leverage and the exogenous shock
of energy prices. We are due for what appears to be a 2% or
less GDP growth rate in 2006, a rate sure to stop the Fed
[from raising rates] and to induce eventual ease at some
point later in the year."
 
From Bill Gross' mouth to Mr. Market's ears...if you happen
to be an owner of 5-year Treasurys.

[Joel's Cautionary Note: If dangling your cash out there
for the chance of a 15% return is hot, then buying options
on T-note futures or options on one of the ETFs that owns
Treasurys is down right sexy! This note comes with a
warning, however: Options are rather volatile and triple
digit returns may become addictive. Click here to minimize
volatility while tapping the fat returns:

http://www.agora-inc.com/reports/OHL/EOHLFB36 

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[Joel's Note: If you are anything like your unmethodical
editor, you probably don't have all the Rude Awakening
articles neatly tucked in to folders and stored for
invaluable future reference. No bother, it's all been done
for you. Check out your sedulous website for this and many
other wonderful tasks it can perform for you. Simply go to:

www.the-rude-awakening.com

Any comments on today's column can be forwarded to me here
at aussiejoel@the-rude-awakening.com

Cheers,

jOEL

And the Markets...