G3 Recap 2-2-11

Main Items:

  • US ADP printed 187k in Jan vs 140k expected and 297k previously. There was a 97k increase in small business employment.

Overseas Data:

  • UK PMI Construction improved to 53.7 in Jan vs 49.5 expected and 49.1 previously.
  • EU PPI increased to 5.3% in Dec vs 5.2% expected and 4.5% previously. Petroleum prices are now up 11% YoY.

Commentary:

  • Big move today was obviously in yields. Judging by the price action, it probably wasn’t driven by the ADP, which is now deemed unreliable after last month’s joke of a print. Most of the market appears to be getting ready for yield ranges to reset higher. Even the ‘bond king,’ Pimco’s Gross, opined today that “Treasury bonds may need to be “exorcised” from model portfolios.”
    The catalyst for a short term move will likely originate, as it usually does, from the payrolls print. The current consensus is for a print of 140k, vs 103k previously. However, there will be multiple seasonal adjustments that could drive a surprise, including the weather, the birth/death model adjustment, and benchmark revisions, among others. I’ll only note here that, in my observations, yield extremes have a tendency to print near payroll days.
    Longer term, the valuation for intermediate term treasuries does not look too bad. Most yield based models for treasury yield that I am aware of use core inflation or core PCE deflator as a dependent variable, and it usually is one of the most important ones. Therefore, current core PCE prints of 70bps is a positive. (Of course, the implication is the current levels of core inflation will persist for a long time, which may or may not be accurate) Based on these models, yields are several standard deviations too high.

    Looking at treasury yields vs OIS swaps, a 5yr OIS swap at 2.06% would be consistent with a Fed hike in March 2013. I would rate this as neutral, given the output gap and UE.
    Finally, there are additional factors, some of which were mentioned in a presentation to the Treasury Borrowing Advisory Committee today. These factors include: a rundown of GSE portfolios, which would reduce AAA supply by ~120bn per year; the maturity of 370bn of TLGP debt by the end of 2012 (chart below); and the implementation of Basel III, which the Treasury estimates will drive 650bn-700bn of Treasury demand. (although the implementation date has been pushed to 2015)

    The general conclusion is that while yields can certainly reprice higher, (especially as we approach the end of the seasonally constructive period) treasuries are not as horrible of a bet as they can be portrayed to be. There are several supportive factors on the horizon that will continue to be supportive of the market after the end of QE2.

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2 thoughts on “G3 Recap 2-2-11

  1. fwd starting 2s/10s steepener? long edz1? treas vs bunds? Agree with range bound thesis, but a bit curious where the implications might take you …
    also, any fears about debt ceiling games of chicken?

    lastly, sad U.K.

  2. Hey qeqe – I mostly believe in various versions of long the very front end. It’s been a choppy trade, but it’s been generally a winner this year, helped by the Treasury’s announcement last week that it was winding down the SFP program. I’m a bit wary of positions farther out – receiving 1y2y, 2y2y type trades seem to be pretty popular, but it’s much harder to handicap where the appropriate clearing level should be for those positions.

    I don’t have a position in 10’s mostly because of the double sided tail risk. I would want some confirmation from the data before doing anything.

    I’m not too worried about the debt ceiling, mostly because knowledge of the risk appears to be fairly well disseminated already, and it didn’t move the markets a ton in the mid 90’s.

    A bummer on UK rates. I think I understood the logic for a short, but the vol and the rolldown presented a very advantageous trade profile that, for me, basically provided cheap insurance for a UK slowdown or shock in the next couple quarters. I have the structure on in options space, so I know what the downside is.

    Both trades present good offsets to my broadly procyclical portfolio. Given the position sizes, my plan is to keep the trade on through expiry.

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