EconPundit

In my view, the bond market is likely very soon to put in a temporary bottom and rally sharply for at least a couple of weeks. However, it would not be surprising if first the yield on 10-year notes rose even further, to or above the 4.64% high set last summer. That would trigger technical selling on top of the extreme bearishness that already exists in the portfolio and hedge fund communities, creating an excellent recipe for a (temporary?) extreme oversold condition and a bottom. Thereafter, even mildly weaker-than-expected economic data or (quite possibly) a stock-market breakdown could spark a sharp, sustained rally in bonds. This might carry yields down 30-60 basis points, back toward 4% on the Treasury 10-year note.

Bond yields currently look very stretched to the upside relative to historical norms under an adaptive expectations model of behavior. At 4.50%, the constant-maturity yield on the Treasury 10-year is 1.65 standard deviations above normal relative to the 3-year moving average of short rates and a risk premium. This is UNPRECEDENTED for a period in which the Fed has not yet even begun to tighten -- in fact, under its latest policy directive the Fed is saying they can be "patient" before raising rates! Yet the bond market is already priced for a roughly 3.0-3.25% equilibrium money-market rate, roughly 200bp above the current trailing average. In past cycles, this degree of pessimism about future rate changes has never been seen prior to any rate hike by the Fed.

In its current pricing, the bond market closely resembles its state just prior to the 1987 stock-market crash. At that time, the 10-year Treasury went to around 10% while the trailing 3-year average of the money-market rate was around 6-1/2%, and the risk premium norm for the 10-year was around 160bp. Thus, at 10% the 10-year was pricing in a FF rate of approximately 8-1/2%, or 200bp above the recent trailing average. The panic that existed at that time in the fixed-income market helped to trigger the dramatic change in equity market sentiment that reached fruition in the October 19, 1987 crash (-22% in one day). What is extraordinary is that today, many analysts have no problem speaking of a 10-year yield rising to or above 5% -- up still another 50bp -- in the same sentence as predicting strength in the stock market.

My guess is we'll see lower lows in bonds next week, as market participants factor in further bearishness based on: (a) strong economic activity data and expectations for more, including the employment report on May 7, (b) the removal of the "patient" clause in the FOMC directive on May 4, and (c) looming Treasury debt supply with the May refunding. These three forces are apt to drive yields up to or above 4.64% from 4.50% today. If that happens, it could present a fantastic tactical buying opportunity for long Treasuries.

Cash Treasury data through April 27 show that season tax payments to the federal government are coming in on the stronger side of expectations, and are far higher than the pessimistic media types and analysts would have you think. By my calculations, the combination of April nonwithheld individual income taxes and corporate taxes is up 3.8% year/year at this point, and in fact these receipts are even higher than they were at the same point in 2002. Meanwhile, tax refunds are turning out to be not as huge as had been anticipated as a function of last year's tax rate cut acceleration.

Thus I'll repeat what I have said before: the US budget balance trend is far better than either official estimates of $475-$525 billion for FY2004 would have you believe, and the media is not reporting this story. The evidence was solidly on this side before April, and now it is even stronger.

The 4.2% advance estimate for Q1 real GDP growth was a bit below expectations, but only because inventory accumulation remains very modest, at $18 billion for nonfarm businesses. With final sales remaining sturdy -- up 3.9% annualized -- there remains a lot of room for stocking acceleration to occur, and that will provide support to production for many months to come.

The more interesting news in this report was:

1. Personal income is moving up fast. The quarterly data indicate that March income figures to be reported tomorrow will be up sharply. If there are no revisions to January and February (unlikely), then the March change would be +1.3%.

2. GDP-based inflation may be firmer. The quarterly figures (+2.5% for the chain-weight GDP price index, +3.2% for gross domestic purchases) are probably inflated by seasonal adjustment problems, since we saw the same type of surge exactly a year ago. That said, it's clear the year/year changes in the GDP price measures have bottomed.

On balance, this report provides some fresh rationale to expect more speculation about an early Fed monetary tightening. Growth is solid, inventories are very lean, production should move up rapidly in the period ahead, and pricing has stabilized or firmed. This report gives new reasons to expect a sharp down trade in bond prices going into the May 7 employment report. Continue to look for 10-yearTreasury yields in the 4.60-4.70 range by that time (currently 4.53%).

For weeks, we have opined that markets were drawing toward a point when there would be sharp trades against the large leveraged positions that have built up among hedge funds and proprietary traders. This was expected to cause steep declines in commodities (especially precious metals and related shares, and certain industrial metals), a sharp rise in the dollar vs. the yen (where speculative dollar shorts have appeared huge for some time), and further drop in bond prices (especially in low-grade issues such as junk corporates and emerging markets), and probably a sharp slide or crash in certain equities.

These trades all now appear to be in progress or imminent. Copper, gold and silver have all gotten clobbered today, and gold shares are being routed. Bond yields are up 5 basis points, which seems counterintuitive if commodity prices are deflating but is consistent with the notion that there are huge correlated leveraged positions across markets, and as one collapses the pressures grow for the others (long bonds, in this case) to be unwound. Stocks are slumping, especially in the small-cap arena where there has been rampant speculation and exit strategies are more difficult (the Russell 2000 index is down almost 2% right now. Finally, currency markets are on the brink of a break as well, particularly the yen/dollar rate which is bumping up against the 200-day moving average of 110.20 or so.

Now that the commodities are already in breakdown mode, the next areas for fireworks should be currencies and stocks. You can't rule out a huge move in the yen, perhaps to 115-120, and the NASDAQ in particular could plunge if leveraged players start to experience liquidity difficulties amid stunning losses.

The March new-home sales report has two messages: (a) housing demand continued to boom through the end of the first quarter, but (b) the home construction industry is showing evidence of dangerous over-capacity, which could lead to a major downturn in its fortunes within a year or two.

Sales of new single-family houses jumped 8.9% last month, which should not have been overly surprising given that the purchase index of the Mortgage Bankers Association survey of mortgage applications was extremely strong during the period (up 23.5% year/year). The 1.17 million (annual rate) average level of these sales during the first quarter is a new record, and once again illustrates how the environment of sustained very low mortgage interest rates and briskly rising home prices has fostered buoyancy in demand for new dwellings. Moreover, there is considerable evidence that the accommodative character of housing finance has pushed people over time into larger and more expensive homes.

The dangerous flip-side to these phenomena is also present, however. The potential exists for a huge bust in the homebuilding sector should interest rates rise much further or household wealth come under siege, or both. Despite these record sales levels, builders are accumulating inventory of unsold homes at a rapid clip -- up 12% at an annual rate over the past four months. Thus far there has been no penalty against builders for maintaining maximum production rates, but what this signals is even a moderate slowdown in sales could send inventories spiking higher. That overhang could put a big dent in their profitability as they are forced to reduce production and also cut selling prices to eliminate the overstock.

The explosively strong March durable-goods report (new orders +3.9% excluding the volatile defense and aircraft groups, and revised up an additional 1-1/2%) opens the door to a final catharctic down trade in US bond prices over the next two weeks, which should drive the 10-year Treasury yield up to around 4.60-4.70% and set up a good short-term buying opportunity. The orders, shipments, and backlogs data could not have been much more robust. In orders, steep gains were seen for both capital items and durable materials. Shipments of nondefense capital goods -- an indicator of current capital investment and exports -- were up 10.7% annualized last quarter, compared to a 5.4% trend when just January and February figures were available. Including revisions, unfilled order backlogs for nondefense capital goods other than aricraft were 1.5% higher than before. This is a series Fed Chairman Greenspan watches very carefully as a leading indicator for core manufacturing production trends.

The bond market now seems poised to undergo a final sharp sell-off into the first week of May, which could create an excellent tactical buying opportunity. Investors probably will panic going into the next major round of economic news that week -- the ISM surveys and the employment report -- because all the activity data is super-strong and they will fear that another month of the same will set the Fed into motion as far as credit tightening. Also, there is a lot of Treasury debt supply due between the last week of April and the second week of May. Put the two together, and it creates an atmosphere that is ripe for the market to become oversold, albeit not until we get to notably higher yields than currently prevail. Buyers should be very patient for the next two weeks, then get ready to load the boat.

Today was another awful day for the leveraged investor community -- hedge funds and proprietary trading desks at large banking firms -- who have been crowded into "reflation trades": long commodities (esp. precious metals and related shares), long Asian equities (esp. in China and related nations), short dollars (esp. against the yen), and long credit product such as mortgages and high-yield corporate issues. These positions have all been highly popular among speculators, on the theory that the Fed will keep short-term rates low for long enough to keep global demands pumping, leading to firming prices and rising profits. A week ago, on April 14, I opined that the damage done to these positions was only beginning and would get much worse as mounting losses forced a panciky unwind of these correlated positions.

This process of disorganized exiting of crowded positions, and resulting sharp price adjustments, now appears to be in full swing. The biggest losses today were in precious metals shares, as the HUI "gold bugs' index" plunged below its 200-day moving average for the first time in over a year and shed almost 7% of its value. That means all the rise since mid-October has now been wiped out, mostly in the past two weeks. Gold and silver also slumped, by 0.7% and 3.6%, respectively. But the pain for leveraged players does not end there. Bond markets were pummeled, with Treasury yields between 2 and 10 years rising anywhere from 8 to 13 basis points. Thus, owners of fixed-income securities on the basis of the wide spread between their yields and the 1% federal funds rate were clobbered again. Meanwhile, bearish dollar bets were hammered too; the US dollar index jumped about 1-3/4%, with both the yen and euro weakening. Finally, stock prices fell steeply, with the NASDAQ down more than 2% and the S&P 500 index off 1.6%.

The evidence that this is a correlated position unwind can be seen from the fact that the simultaneous moves appear inconsistent from the standpoint of fundamental analysis and typical relationships. The dollar is rising even though bond and stock prices are both falling -- market developments that normally depress demand for the US currency. Bond yields are rising even though commodity prices are falling, which most of the time would be interpreted as disinflationary and therefore bullish for bonds. What ties it all together is not a consistent economic view, but rather that (a) there are huge positions in existence all predicated on an inflationary monetary policy, and (b) participants have grown much more fearful that monetary policy will turn less accommodative soon. It's not that people expect a huge Fed tightening, it's just that short rates have been so low for so long that enormous speculations have cumulated and discomfort with the underlying assumption of a rigid Fed has grown.

Look for a lot more of the same to come. The dollar should break up another 2-3% in short order. Bond yields likely will move soon up to 4.60-4.65%, as we have been anticipating -- probably before the next employment report in early May. Stock prices have a lot further to fall, especially those with more speculative components such as the NASDAQ. Look out below.

The 0.2% drop in total industrial production for March exaggerates the softness of this monthly report. In truth, the figures presented here by the Federal Reserve are quite consistent with other evidence -- including robust regional manufacturing reports from New York and Philadelphia yesterday -- that goods production in the US remains on a strong course. The fact that the monthly figure was soft should be seen as primarily a correction of the exceedingly robust February increase, and not a change in the underlying trends.

Excluding motor vehicles, manufacturing output climbed 0.2% last month on top of a 1.0% rise for February (revised up from 0.9%). This core group rose 6.8% annualized last quarter, up from 5.9% in the final period of 2003. Moreover, the March level is 0.5% above the first-quarter average, so we're on the same brisk upward pace as we enter the second quarter, too. Certainly the April regional survey results indicate no loss of production momentum early in the new period.

At 75.2%, the overall factory utilization rate remains historically low yet is up sharply from the 72.6% cyclical low point registered in May 2003. There remains a long way for this usage measure to rise before it moves into territory that is traditionally problematic from the standpoint of resource scarcity. Thus, despite the unusually high vendor performance indexes, which suggest spreading bottlenecks in the production chain, it is difficult to see much risk of a genuine inflation problem developing anytime soon.

March US fiscal results (deficit $72.7 bn) underscore the high probability that the full-year budget balance will be much better than official estimates. We are now halfway through fiscal 2004, and based on a tracking method that has shown good success in the past, the results point toward a final budget deficit in the $400-$415 billion zone, rather than $475-$525 billion as most official projectors have indicated.

When will you read in the New York Times that the budget is tracking far better than expected? Don't hold your breath.

Over the past week enormous damage has been inflicted on the speculative community in the financial markets, as crowded positions that were predicated on a theme of sustained, central bank-induced global reflation -- long commodities, short dollars, long high-yielding bonds, and long Asian equities -- have been routed across the board. Perhaps the biggest leveraged bets have been in favor of the yen vs. the dollar, and in favor of precious metals and base metals in dollar terms. Additionally, many participants had allowed themselves to grow very long in some relatively illiquid long-term bond markets with low credit quality, as well as in mortgage products, taking advantage of the positive carry enabled by a 1% federal funds rate.

In serial fashion, these trading positions have blown up. And ironically, some of the damage to this "reflation" bet was caused today by a bad inflation report! (The CPI jumped 0.4% excluding food and energy in March, with widespread unfavorable surprises). The combination of strong employment and retail sales reports from March and now bad inflation figures caused 10-year Treasury yields to surge almost 70 basis points in just 15 trading days. This inflicted significant losses on those with big carry-trade positions, no doubt pressuring them to reduce exposures in the other places where they had placed large wagers rooted in the reflation theme: long commodities, especially precious metals, long yen, and long Asian stocks. However, since all those positions were extremely crowded also in the leveraged community, we now see them all going against the speculators simultaneously.

In our view, these market setbacks are not yet over. The chart patterns look very bad for gold, gold stocks, silver, copper, the yen, and long-term Treasuries. Soon they may also turn down definitively in the broader equity market. We look for important further moves in the same directions over the coming days. Specifically, the 10-year Treasury (where we turned negative about two weeks ago) will likely test the 4.60-4.65% yield level (versus 4.44% now) before the next employment report, and it could happen much sooner. Gold prices flirted with sub-$400/oz. this morning, and are apt to make a sustained push below that benchmark very shortly, perhaps down to $360-$380. Gold stock indices will follow suit. Meanwhile, after bursting above its 50- and 200-day moving averages, the yen/dollar rate seems poised to move from today's 108.40 up to retest the recent highs at 112.20 or so.

Should all these market developments unfold, there will be massive losses in the speculative trading community, both among hedge funds and bank proprietary desks. It wouldn't be unpreedented for an across-the-board trading debacle of this kind to trigger rumors of business failure by one or more entities.

It appears service companies, who resisted adding workers to an unusual degree in the past 2-1/2 years as the economy recovered, are finally relenting. The percentage of nonmanufacturing industries expanding payrolls over the past three months is up to 62.1% by my calculations, versus 55.2% in the final three months of 2003 and 44.8% at this time a year ago. This services diffusion measure is historically a good leading indicator for aggregate job growth when it turns up or down. Meanwhile, manufacturing firms' hiring behavior hasn't changed much since the end of last year. Factory production workers continue to decline very slowly each month, in the single-digit thousands.

Although labor demands have likely improved, there are plenty of grounds for considering the job market as still pretty soft. The upturn in payrolls over the past several months is probably best viewed as a catch-up for last year, when the household survey was showing much better job increases than the separate poll of established firms. Since the start of 2004, however, the household measures have turned softer. Private nonagricultural employment by that measure was down 175,000 in March and has been essentially unchanged on balance since November. The employment/population ratio fell another 0.1% last month, so it is back to the lows and has completely reversed the rebound that seemed in train toward the end of last year and start of this year. All of the 0.1% rise in the total unemployment rate (to 5.7%) last month was among job losers, rather than new or re-entrants to the labor force. In fact, labor force growth remains very sluggish (0.1% annualized over six months, 0.6% year/year), signaling there remains a lot of doubt about companies' willingness to add workers. Finally, wage disinflation is still apparent -- the trend in average hourly earnings is 1-3/4%, compared to 2-1/2% to 3% at this time last year. This means that nominal incomes aren't getting much kick from the upswing in payrolls growth.

Bond yields skyrocketed this morning when the Dept. of Labor reported an almost 400,000 increase in payroll jobs from the previously reported level (+308,000 for March, and another 87,000 added to the prior two months combined via revisions). The 10-year Treasury yield at one point was up 27 basis points to 4.15%, an incredible move and one that more than completes the reversal of the robust rally that followed the last employment report. This makes the charts for US bond prices look quite negative -- you have a pole vault up, followed by a couple of weeks of sideways trading, and now an elevator shaft down on the other side. Everyone who bought bonds between 8:31 AM on the morning of the last jobs report and yesterday afternoon and held them lost money, indeed, a lot of money.

Moreover, there is now an accumulation of data that from a fundamental perspective should be very unnerving to bond investors, especially those playing the "carry trade" of betting on a stable, extremely accommodative Fed for the medium term. I noted yesterday that the ISM report was very bad news for US financial assets, both stocks and bonds, because it showed a 25-year high in the degree of bottlenecks in manufacturing and a 7-year high in the price component. Now we see that employment growth has finally picked up to a notable degree, rising on average more than 170,000 per month in the first quarter compared to roughly 30,000 per month over the second half of last year. This combination of (a) tight resources in manufacturing, (b) stronger input price pressures, and (c) improved labor demand will escalate calls for the Fed to start raising rates before the end of the year. The bond market obviously is already factoring in that likely future crescendo in the financial chorus.

The same conditions are apt to weigh down heavily on stocks as well, perhaps very soon. Support for equity valuation from extremely low bond yields is already starting to be withdrawn, and soon the speculation about a hostile Fed will grow, all at the same time that the input price statistics indicate profit margins are under siege. These are precisely the kinds of sentiment changes that could propel the Dow index below 10000, and that handle change may have important psychological repercussions for the small investor community that has been nervously returning to stocks due to the lack of up-front returns in money market and fixed-income investments.

The March ISM manufacturing survey data, coupled with the (delayed) release of February PPI statistics, yield an impression of significant bottlenecks in US production that are driving up cost pressures and driving down profit margins. Consider:

1. The vendor performance index (percentage of respondents reporting slower delivery speeds) surged nearly 6 points last month to 67.9%, the highest in a quarter century (since May 1979).

2. The PPI report showed a 0.9% surge in prices for intermediate goods and materials other than food and energy. This was dramatically higher than any prior reading in the past few years, and it suggests that suppliers are taking advantage of spreading bottlenecks to hike prices at this time.

These indicators are negative for US financial assets, as they imply increased pricing pressure at a time when incomes are sluggish and thus the ability of firms to pass along cost increases to final purchasers is very limited. It would not be surprising if bond yields experienced a stiff upward tug in the near term as a result, and that removal of the low-rate support for equity valuation could act to severely depress stock prices over time.

Meanwhile, the ISM manufacturing export orders index jumped to 62.0% last month, pushing the export-import differential to +5.2%, the firmest in seven years. This could be a sign that the dollar's weakness is already generating an underlying improvement in the US international goods trade balance. If so, a rebound in the dollar's value against other key currencies (especially the euro, in whose zone growth has been very weak) should be in the offing.