Curve Balls and Change-Ups

I stand corrected. The 10-year auction was weaker than expected. Concerns about the deficit, $15 billion of 30-year bonds coming due tomorrow and a very strong 3-year note auction were the culprits. Keep mind however, at $23 billion, this was the largest 10-year auction ever.



Fed Funds rate was unchanged. The Fed sees conditions warranting excessive policy continuing, but a leveling off and stabilization of conditions. It sees modest growth (because of inventory replacement) and resource slack keeping inflation under control. Fed will purchase up to a total of 1.25 trillion Agency MBS and $200 billion agency debt by year end. The FOMC stated that it could end treasury purchases as soon as October.

The reality is that the Fed sees what most of us see. The worst is probably over, there will be a pop to economic growth, but that is a correction on the downside overshoot. Growth that follows will be below historic levels (probably 1.5% to 2.0% area).

What will happen to treasury yields. As I have said for some time, they will move gradually and modestly higher. Growth, debt issuance and dollar printing will force long-term interest rates higher. Foreign investors will moderate the pace and extent of long-term interest rate rise, but not prevent it from happening. Economic growth will be slower than what has been typical in recent cycles as the consumer cannot return to previous spending levels with out a return to prior, irresponsible levels of leverage.

One must now look at the corporate bond and preferred markets. Sectors such as industrials, telecom and utilities may be fairly valued spread wise. This means that their yields could follow treasury yields higher. In the financial arena, the large ex-TARP banks are almost fairly valued. Their bonds and preferreds should be purchased for income. The weaker large banks are also fairly valued given their glow-in-the-dark assets. The best preferred values lie in National City (guaranteed by PNC) and Countrywide (guaranteed by BAC). Note: Merrill trust preferreds ARE NOT guaranteed by BAC. High yield bonds are fairly to over valued given fundamentals and projected defaults.

Fixed income investors should continue to ladder or barbell. Ladders should oveweight the belly of the curve while barbells should overweight the short end of the curve. Neither barbells nor ladders should extend past the 10-year area of the curve.

What to buy:

CDs are offer the best values on the very short part of the curve, callable agency bonds two to five years out and large bank and finance bonds from five to ten years out.