A Greek Satire and the Seasonality of Long-End Treasuries
By Zach Berg, CFA
February 13, 2012
It is rather ironic that ancient Greece is the origin of the words democracy and economy, and yet both appear to be in complete disarray before the world’s eyes. Perhaps it was a week late for the reference, but the Greek drama or tragedy played out last week as if one were watching the movie Groundhog Day. Initially optimism grew that a deal would be worked out reaching a crescendo on Thursday’s announcement that Greek political leaders had agreed to terms. Hold that thought though, because EU leaders who had agreed to a new rescue package wanted further assurances from the Greeks that this time would be different and the agreed to austerity measures would be implemented in the agreed upon fashion. The hope of a completed deal collapsed and in turn was replaced with brinkmanship from each side. Greek political leaders resigned, the Greek protests already occurring turned violent, and images of riot police and angry mobs became front page stories. These developments led to investors turning risk averse and a corresponding flight to quality occurring. Throw in $69bln worth of 3yr, 10yr and 30yr Treasury auctions and this was last week’s trading backdrop in a nutshell.
Treasury yields came under mounting pressure as last week progressed and the markets were tasked with taking down increasingly longer duration at each successive Treasury auction. Tuesday’s 3yr came right on the screws at auction time, but the lower demand figures raised concern ahead of the 10yr and 30yr auctions. It turned out that Wednesday’s 10yr went off decently, however the history of 13 consecutive 30yr auction tails (higher auction yield than expected based on the 1pm when-issue level) had traders anxious heading into Thursday. The pressure only grew Thursday morning on the announcement of an agreement amongst Greek’s leading political parties which improved risk sentiment and helped push long-end yields to 3.24% right at the 1pm auction time. The 11bp backup in yields proved to be plenty of pre-auction concession, as the 30yr priced with only a 1bp tail producing a win for a bond that had averaged a 3.5bp tail during the previous 13 auctions. Although it was a roller coaster, especially for the long-end, Treasury yields ended last week only marginally higher by 4-6bp in 2yr through 10yr maturities.
Elsewhere in fixed income, corporate bond spreads extended their winning streak to nine consecutive weeks of spread tightening with the Citigroup Investment Grade Index finishing the week 4bp tighter at 188bp. That brings broad investment grade corporate spreads to their lowest level since August 8th, 2011, and increases the return rally to 4.577% from December 1st through Friday’s close. However, there was a divergence between these spreads and their corresponding credit default swap derivatives, with the Markit CDX IG NA 17 Index widening just over 4bp on the week. In agency and mortgage-backed debt, spreads remained largely unchanged, according to Yield Book figures.
Entering this week, Sunday’s Greek parliamentary vote passage of €3.3 billion of austerity measures necessary to receive a second EU bailout package has riskier assets rallying and Treasury yields moving higher. The next awaited step will be Wednesday’s EU finance ministers meeting, where the bailout package will need to be approved to clear the way for Greece to receive its 130 billion euros of funds. If, and that still may remain a big if, but if the Greek drama surrounding the approval of a second bailout package is passed that does not mean that Greece will avoid a default situation and a triggering on its CDS contracts; however, it may remove the temporary boost Treasuries have received requiring a re-pricing of yield levels. How much of a recalibration? The answer for yields likely lies somewhere between Thursday’s highs and Friday’s lows.
As previous bond market commentaries have discussed, the front-end of the yield curve is still likely in tow from the Fed’s commitment to maintain a lower for longer policy on interest rates. Interestingly, the reaction from the Fed’s FOMC statement that led fed funds futures pricing expectations of rate hike out to late 2014, have faded back to expectations of an early 2014 hike. The reasoning behind this adjustment and disregard for the Fed’s communication is likely for two reasons. First, the Fed’s ability to predict economic conditions 2-3 years out is very difficult and, based on recent better than expected economic data, the fixed income markets believe the economy will improve faster than the Fed. Second, Chairman Bernanke’s term as Fed Chairman ends in early 2014 leaving a regime change possible, especially given this year’s Presidential election. Some Republican candidates, including Mitt Romney, have stated they would not reappoint Bernanke as Fed chairman; hence, the fed funds futures are placing the Fed’s statement to maintain rates low through the end of 2014 as a very “conditional” statement. Fixed income investors will get more color on the Fed’s mindset with the release of the FOMC meeting minutes this Wedenesday. Nonetheless, the change from a mid to late 2014 hike to an early 2014 hike has only relatively small transitory effect on front-end yields.
Further out the curve though, the long-end is entering a period of time that has historically seen yields move higher. Examining 30yr yields from 1990 through 2011 displays that on average, mid-February to May have witnessed higher long-dated yield levels. This seasonal direction in yields has also been shown to hold in 10yr Treasuries, with the St. Louis Fed conducting a study from 1962-2009 on the constant maturity 10yr showing a similar pattern.
This is important to keep in mind that from a seasonality standpoint yields would appear to be biased to move higher over the upcoming months. It would also appear that some traders are beginning to question the fortitude of yields at these levels as well. Many have continued to build on short positions set at the end of January when 30yr yields were below 3%, based on CFTC Chicago Board of Trade short contracts on the ultra long bond futures, which rose last week to a five week high. It is important to note that these short positions recorded by the CFTC have seen much loftier levels, such as last August when they were twice as large. Combating this theory of first half Treasury weakness will be the Fed’s Operation Twist purchase program. Although, the bias may be for yields to rise, a simple supply and demand equation in which the Fed has thus far accumulated an astonishing 91% of long-dated supply through a little over half of its planned program displays the huge anchor the Fed has thrown down on the long-end. Now that it appears the Greek drama may be moved to the back burner, the market’s attention may refocus on the economy, making this week’s economic releases the likely candidates to move yields with the support and resistance levels below on 2yr, 5yr, 10yr and 30yr Treasuries provided as a guide for the week.
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