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Monday, August 4, 2008

US Treasuries, US Dollar and Commodities

An avalanche of new debt is about to hit the treasury market. Not just this week, but for months and possibly years to come as the U.S. economy plunges into a deep, prolonged and nasty recession full of government sponsored bailouts and stimulus packages. This massive new supply of debt will hit the markets just as demand begins to wane. The rest of the world is now much less able and willing to support both the reckless U.S. consumer and government.

As equities (S&P 500, grey area) slid into the abyss thru June and July, fixed income couldn't find the usual safe haven bid. Instead, yield consolidated using the 4% area as support. Expect a break out to higher yields as supply overwhelms demand.

The US dollar will continue to stabilize as it becomes apparent the rest of the world hasn't in fact 'decoupled'. With the Fed done cutting, the 'dollar down bubble' may abate. This will help crush commodities...

The oil price insanity is probably over. Oil may rally, but fail at the old high before plunging below even $50 or $30 a barrel.

Should commodities collapse, and they will, the single major source of funds propping up the U.S. debt markets will suddenly slow to a trickle. After some lag, this would translate into less demand for U.S. government debt as the flow of 'recycled' petro-dollars slows, resulting in an agonizing spike in yields...

Fewest Treasury Traders Since 1960 Hit Taxpayers (Update4): “For the first time since 1960, when it created the network of securities firms obligated to buy and sell Treasury bonds, the U.S. government has the fewest bond traders making markets in its debt and a bigger burden for American taxpayers financing record federal deficits.”

That can lead to only one thing: Higher interest rates and greater volatility…

“Fewer firms bidding for U.S. bonds means “you're going to have sloppier auctions,” said Mark MacQueen, a money manager in Austin, Texas, at Sage Advisory Services, who traded Treasuries at dealer Merrill Lynch & Co. in the 1980s. “The taxpayer and the government are paying more no matter what happens.”

While the interest rate on the benchmark 10-year Treasury note today is less than half the 9.14 percent yield of 20 years ago, the dwindling number of dealers and contraction of credit markets means that yields on 10-year notes sold this year have averaged 1 basis point higher than in pre-auction trading, compared with no difference in 2007, data from Stone & McCarthy Research Associates in Skillman, New Jersey, show. In the three years before 2007, such sales drew a yield just below the pre- auction rate. One basis point, or 0.01 percentage point, spread over $171 billion -- the amount the Treasury said it may borrow this quarter -- represents $17.1 million in interest.

Traders refer to yields that are higher at auction than typically forecast as a tail. The Treasury's July 22 sale of 20- year Treasury Inflation Protected Securities, for example, drew a tail of 5 basis points, or 0.05 percentage point, according to RBS Greenwich Capital in Greenwich, Connecticut.”

With all sources of tax revenue, from corporate profits to residential property taxes and retail consumption taxes, and with government obligations sky rocketing as bailouts and stimulus packages are crafted, expect some of the largest deficits in U.S. history.

“The paucity of primary dealers coincides with the largest borrowing requirement in American history and the acknowledgment by the administration of President George W. Bush that the U.S. will finance a budget deficit totaling a record $482 billion next year. When the dealer system began 48 years ago with 18 firms, the U.S. had a $300 million surplus. The group has shrunk from a peak of 46 in 1988.”

Most important are INDIRECT BIDDERS.

“The Treasury this week will sell $17 billion of 10-year notes in its quarterly sale of the securities, the most since 2003. It will also auction $10 billion of 30-year bonds, the most in two years. The government said July 30 that it's considering more frequent auctions of both securities, and will announce a decision in November.

Dealers are just one category of participants at auction and a smaller number doesn't automatically doom the government to higher rates or guarantee profits for firms.

Indirect bidders, a class of investors that includes foreign central banks, bought 27 percent of the two-year notes that sold in the past year. That compares with an average of 34 percent in the preceding 12 months.”

The rest of the world has financed the U.S. lifestyle. It does look like they are less able or less willing to do so now. The effect on interest rates could be catastrophic.

The era of low interest rates in the U.S. may soon be over…

U.S. Treasuries Decline Before Auctions of 10-, 30-Year Debt: “Treasuries declined as some traders speculated last week's rally was overdone given the U.S. government's plan to increase sales of long-term securities and investors became more bearish on the debt.

The decline pushed the yield on the 10-year note up from near the lowest level since July 17 before the U.S. sells $17 billion of the securities on Aug. 6, the largest amount since 2003. It will also auction $10 billion of 30-year bonds the next day, the most in two years. An index of sentiment showed investors were bearish on Treasuries for a fourth week.

“There's a lot supply coming this week and the market may well find it difficult to digest it all,” said Christoph Rieger, a fixed-income strategist at Dresdner Kleinwort in Frankfurt. “The market is looking increasingly vulnerable at these levels.””


Mista B said...


What you wrote definitely makes sense. I am nevertheless curious how a number of issues will work out. For example, Europe is clearly in big trouble economically. To me, they look worse off than the U.S. well into the future. U.S. investors who put money there six years ago when the dollar was strong benefited from the subsequent dollar weakening. Same for emerging markets, except the gains were even greater. Now, though, with the dollar so much weaker, I have to wonder what's going to support those stock markets. If there was a stock market bubble in the last five years, it was in emerging markets. The charts say they've lost momentum. Assuming a selloff (just my opinion, but I think it's all but inevitable at this point), where will the money go? The U.S. has a myriad of issues, and I despise the socialization that's taken place at so many levels. It nevertheless remains the freest country in which to conduct business.

This likewise applies to a selloff in commodities. My point is that the money has to go somewhere. Maybe it just stays in cash and supports the financial institutions, but I doubt it. Government bonds seem like the safer play.

My lack of understanding centers around the size of these markets. I've heard that the currency and bond markets are much bigger than the equity markets, but I've never seen comparative numbers. Same thing for commodities. Along that line, to what market would a buyer of oil who sells his oil turn to? Cash or bonds seems more likely than equities.

Anonymous said...

Thanks Ben. Good report.

So if oil is oversold, what is your thought on DUG? Time to take some profits?

I'm getting nervous with SKF as well. All the gov't supports/programs are keeping financials from going their intended path...DOWN!

Mista B said...


One more thing I hasten to add, I'm not advocating going long the U.S. government bond. The only thing that would make it a good play is if the Fed gives up trying to inflate us out of this mess (and I don't think that's going to happen).

For fixed income, I think munis will by and large be pretty safe. Some are predicting massive bankruptcies, but I think they're forgetting a few things. One, people have to live somewhere, and the great majority of people aren't losing their homes. Thus that tax revenue can be counted on. Two, municipalities can cut expenses just as companies can. They already are. They clearly upped their spending over the past five years, but it can be cut just as quickly. Municipalities would be doing themselves and their constituents a huge disservice by defaulting on their bonds. Some will go under, but overall it'll be relatively small.

I'm also looking at the high-yield space, though it's far too early to get in. I want to see yields over 15% (at least). The bonds are still getting sold off hard. Probably still a good bet to short. There will be some nice bargains soon though.

Brazilian bonds are another area of interest for me. Given the number of times they've defaulted over the last century, it's probably be to be tempered about them, but given how far their economy has come and their extremely positive demographics, they should be a good bet for both bonds and stocks over the next couple of decades. Their stock market looks overheated at the moment, but I think a signficant correction would be a buying opportunity (unlike the U.S. and Europe, imo).

Ben Bittrolff said...


Don't you dare touch SMN and DUG. Keep it.

Today is a big day for commodities. All 19 commodities in the CRB Index are down hard. Something somewhere snapped.

Post pending...

Anonymous said...

Yep...both SKF and DUG popped today. Maybe the Saudi's want Euros per barrel as opposed to USD's!

Anonymous said...

With the way things are going in the global economy and in the US I predict a race to the bottom for all currencies.

Anonymous said...


I closed out SMN when my 36.60 resistance limit order executed. Left a fair bit on the table, there.

Ben, I know you and I share the same opinion on the trend of commodities but I felt like the three day move from 50 EMA to 200 EMA was too abrupt.

More on topic, though, with the imminent auction of all these Treasuries and the subsequent jump in rates, what is the best bet? Who is the most interest-rate sensitive? I'm thinking SRS, the ProShares UltraShort Real Estate ETF. I'll be buying a break above the 50 EMA and 200 EMA.

-Mike J

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