Not a surprise considering the news out of Europe this morning, and so it goes that bond prices in Italy and Belgium have gone up more than 1% and as such driving down their yields.  France, Spain, and Ireland saw increases in bond prices as well but not as dramatic.

By the way here is what bond yields recently have looked like worldwide.  Truly an amazing picture!

Government Bond yields:  10 Year Notes

1. The International Monetary Fund could offer Italy between EUR400 billion and EUR600 billion in financial support to give Italian Prime Minister Mario Monti a window of 12 to 18 months to enact reforms sufficient to restore waning market confidence in Italy’s ability to repay its debt, Turin daily La Stampa reported Sunday, citing IMF sources.

2. German Chancellor Angela Merkel and French President Nicolas Sarkozy are planning more drastic means – including a quick new Stability Pact – to fight the euro zone sovereign debt crisis…..Euro-zone countries are weighing a new plan to accelerate the integration of their fiscal policies, people familiar with the matter said, as Europe’s leaders race to convince investors they can resolve the region’s debt crisis and keep the currency area from fracturing

3. The European Financial Stability Facility may insure bonds of troubled countries with guarantees of between 20 percent and 30 percent of each issue to be determined in light of market circumstances. The proposal to attach guarantees of up to 30 percent of future EFSF bond issuances’ worth may create a threefold expansion of the 440 billion-euro ($583 billion) fund.

Runner-up! Black Friday retail sales up 7%

Update 7:30 p.m. EST.

The good news continues…

The biggest bond dealers in the U.S. say the Federal Reserve is poised to start a new round of stimulus, injecting more money into the economy by purchasing mortgage securities instead of Treasuries. Fed Chairman Ben S. Bernanke and his fellow policy makers, who bought $2.3 trillion of Treasury and mortgage-related bonds between 2008 and June, will start another program next quarter, 16 of the 21 primary dealers of U.S. government securities that trade with the central bank said in a Bloomberg News survey last week. The Fed may buy about $545 billion in home-loan debt, based on the median of the 10 firms that provided estimates.

Follow Euro trading here:

http://www.sgxniftydowfutureslive.com/index_files/DOWFUTURES.htm

http://www.forex-markets.com/quotes.htm

http://www.kitco.com/ Scroll to bottom for exchange rate.

http://www.xe.com/

To see how FTSE will open go here:

http://www.igindex.co.uk/

or here:

http://www.financialspreads.com/public/

The slide in treasuries continues again and it is clear the Fed has lost any control of the entire curve beyond a one year maturity.   Equity markets are at a very critical juncture right now with QE2 expected to end in June. The reality is equity markets may very well begin pricing the end of QE in the near future, if you consider the Jackson Hole speech hinted at QE2 in August and saw equities price in the policy three months ahead of the November 2010 meeting.

There is no shortage of people calling for endless QE (easily 80% of those voices truly don’t even understand QE).  The environment now though has changed making the options to Fed monetary policy more limited. Probably the biggest headwind facing the Fed is rising interest rates.  The federal funds rate is at 0-25 bp and QE was intended to push down rates further out on the curve and it did work for a while.  The Fed conditioned all of us for low rates with their continual use of “extended period” with each FOMC statement.

The Fed needs to be careful moving forward.  The bond market has clearly signaled they are concerned about inflation, loss of confidence in the Fed and US fiscal policy.  The US is competing with other sovereign nations for capital at the same time they are increasing their supply with growing deficits.  Imagine a shock even to the US economy.  The US is in no position to use emergency stimulus without risk of truly blowing out yields.

Two Year Treasury

After catching a little bid last week the two year has given up all its gains and looks to test the lows again.  The shorter end of the curve had stayed relatively low in yield but has risen more than any other maturity recently causing a bear flattening (higher rates and a flatter curve).  Not favorable for banks or those on the wrong side of interest rate swaps (which is a $458 trillion market).

Ten Year Treasury

Has bounced along a multi year trend line after failing last week.  Looks like it too is set up for failure.  This is not good for housing which is already under pressure and double dipping.  A 100 bp rise in 10 year yield equates to about an 11% drop in home prices.

The commercial real estate (CRE) delinquency rate as a percent of total loans and leases is showing no sign of letting up from its truly parabolic rise. This level of delinquency pretty much wipes out all of the net income from performing credits. A recent report from one of the rating agencies said that over 30% of CRE to be rolled in 2011 did not meet the required standards, whether it be loan to value ratios, debt service, occupancy, etc. Making matters even more difficult is the rising interest rate environment thanks to QE and a struggling consumer.

Howard Davidowitz recently had the following to say about the surplus commercial real estate in the US which helps explain why this delinquency rate will continue to grow.

Online sales have to lead you to question the whole retail selling strategy. We have 21 square feet of selling space for every man woman and child in this country. We already have double of what we need. With the explosion of online sales, what happens to all these retail malls and shopping centers which are marginals? Huge changes are going to be taking place as people continue shopping online…. In the end what do you do with the retail space…This is going to be a huge question for retail in the next ten years, that’s why Walmart is starting to build smaller stores, that’s why Walmart is building more overseas than they are building here. It’s going to be the biggest retail change that we’ve ever seen.”

With the Irish Parliamentary elections less than two weeks away (February 25, 2011) things are getting interesting. The IMF, ECB, EU, German and French banks and pretty much anyone trying to protect senior debt holders must be squirming. The most recent polls show the two opposition groups Labour and Fine Gael with a pretty decisive lead. They could join forces but Fine Gael currently at 38% could also win the 40% needed for a majority without Labour.

What is interesting about this and something bulls should fear is the following quotes from the Irish Times regarding the views of each party towards future bank bailouts.

From the Irish Times

“THE LEADERS of the two main Opposition parties have ruled out any immediate recapitalisation of the banks if they are elected to form the next government.”

“Under that renegotiation, Labour would insist on “burden sharing” with bondholders as part of bank restructuring, he said.”

This would be a wonderful development should senior bond holders be forced to accept risk for a change.

The Fed has officially lost control of the yield curve. First it was the ten year and beyond but now the shorter end of the curve is being assaulted. Just imagine if the Fed said they would be pumping $125 billion into equities each month for six months. Would you ever expect equities to sell off? That is exactly what the bond market has been doing.

The implications of higher yields cannot be understated nor should they be ignored. Bernanke is going to need to do something soon and try and stop the exodus. Today’s three year auction was not a positive sign with a very low indirect bid leaving primary dealers to buy over 60% of the auction. The Fed cannot come out and say QE failed. They either have to cause a sell off in equities (and hope people rush to the “safety” of treasuries) or have to say the economy is improving so much, QE2 can be stopped. The past few days we have heard from three Fed members (two of which are voting members) that they won’t support QE3 but will the bond market wait until June when QE2 ends? Time is becoming of the essence.

Below are two charts of treasury yields from June 1, 2010 through February 8, 2011.

The first chart is of various maturities over time. Yields actually dropped from the August Jackson Hole rumor of QE until the Nov. 2 official announcement. Then rates, primarily the long end really began to move up. Most recently the one and two year maturities have begun to move rather significantly.

The second chart is the yield curve over time.  It is now approaching a record in terms of steepness.  In a normal credit cycle this would be advantageous for the banking sector but no credit is being formed.  Instead the rise for example in ten year treasury yields is having a very negative impact on housing prices, while the five year will put added pressure on commercial real estate that needs to be rolled in 2011.

In a prior post, I commented on the move in treasury yields since QE was first mentioned by the Fed in August of 2010. The very short end of the curve has not budged but as you begin moving beyond one year and especially five years to ten years yields have moved substantially higher.

In the equity markets there is talk of the Bernanke put. If any market should welcome this free option play it should be the bond market. After all, the Fed has communicated regularly their goal of low rates for an extended period and the launch of QE to specifically keep rates low. The Fed has said to the bond market we will put a floor under your security. For some reason though the bond market has decided to take their ball and play elsewhere. QE1 did manage to keep yields low when RMBS was being purchased.

There are a number of possible explanations for this move higher in yields.

• The Fed has encouraged yield chasing and with commodities rising 30% in a matter of months or equities up 25% in five months, why invest in a ten year bond yielding 3%? It would take you ten years just to match a three month return on a long rice trade.
• The economy is improving so quickly that bond investors are demanding higher rates as the Fed will be forced to raise rates sooner than currently forecasted. The problem with this argument is once QE2 was hinted at, rates began moving. Perhaps the bond market was so confident in the success of QE2 and its ability to stimulate economic growth that bond yields responded immediately. The results of QE1 combined with trillions in Federal stimulus did little to improve economic growth so why would QE2 be any different?
• Inflation is a concern and nominal yields are moving accordingly. If you look at the TIPS market though (TIPS are inflation adjusted or real yields) inflation does not look to be much of a concern. The Fed’s target for inflation is 1-2% annually so inflation is a concern beyond ten years but not much at just 36 basis points above the upper target.

5 Year Inflation – 1.50% in August 2010, now forecasted at 1.98%
10 Year Inflation – 1.86% in August 2010, now forecasted at 2.36%
30 Year Inflation – 2.18% in August 2010, now forecasted at 2.55%

• The bond market is beginning to truly question the sustainability of US fiscal policy in the face of growing debt as a percent of GDP. The question I would raise is why now? Why not a few years ago? The reality of investing in US treasuries is you are relying on additional debt to pay back your existing debt. The greater fool theory is the key to this market unfortunately.

The reality behind this move in yields is probably a combination of all of the above. I was surprised in looking at the TIPS data to see how low inflation expectations truly are. I think the inflation or deflation argument comes down to one simple truth. Does QE choke off the remaining final demand in the economy before velocity explodes the money supply? My vote is the former. The bond market is sending a signal and one that needs to be watched as it will have direct implications on future monetary and fiscal policy. Let’s hope it finally forces some discipline at the Fed and DC.

Should you worry about inflation?

Many investors don’t care about what is happening to long term interest rates as seen on today’s TYX chart (30 year bond yields).

But … should you worry about long term yields?

The answer is yes, and the reason is that it has a correlation relative to the level of inflation.

Up until now, consumers haven’t really been concerned about inflation.  This attitude is probably similar to people and diseases … most people don’t worry about getting cancer until after they get it.

For those who look at a long term monthly chart of the 30 year yields, they know that we are at the very cusp of ending a 15 year down trend, with the possibility of beginning a new multi-year up trend.

We won’t show that monthly chart today because we post it every day on our Advanced subscriber site.  However, we will post the current weekly chart of the 30 year yields.

As you can see on today’s weekly chart, something very significant happened last Friday.

The 30 year yields jumped up and above the June 2009 to February 2011 resistance line.  This is implying that Bernanke and the Fed have lost control over keeping rates interest rates low.   In reality, they probably don’t mind because this could be construed as an opportunity to inflate away current debt levels.

In any case, the direction of the current trending should be of concern to consumers and it should be the basis for a change in their long term personal strategies.

Some mixed messages come out of this week’s CFTC Commitment of Traders Report. Below are six charts with my best estimate of what the data is telling us. The three key takeaways are

• Commercial traders appear positioned for further bond weakness

• Commercial traders are reducing net short positions implying copper weakness

• Retail traders are positioned for further USD weakness, implying USD strength

Bonds

Looking purely at the relationship to 30 year yield and the SPX, this chart implies that further bond weakness (lower price higher yield) would be a positive for the SPX. This cannot be taken purely at face value though. There are many implications to a weakening bond market beyond this chart. Still, the data below would imply continued equity strength.

Bonds – Commercial Net

Commercial positions continue to move towards a more net long in the face of 30 year weakness.  At face value this chart would imply further bond weakness to come.  It’s important to note though that commercial positions are approaching a 52 week high.

USD – Commercial Net

This is a tough one to read.  The commercial trader position is net long and matches that of the prior 52 week high.  It is very possible their net long position grows but considering this position relative to the prior 52 weeks, it is quite possible they begin getting more short which would imply USD strength.  The USD has bounced off key support which would further argue for a reversal to a more short commercial net position.

USD – Commercial VS Retail Net

This next chart is that of the non reporting positions versus commercial positions.  Non reporting (retail) are relatively short versus prior times in the year so there is fuel for a short squeeze in the USD.  Hard to make any definitive call though.

Copper – Commercial Net

This is a rather interesting chart.  Copper caught a nice bid the past week yet the commercial traders are not buying it (literally).  They appear to be getting more net long (this  chart is inverted for comparison sake) which would imply pending copper weakness.

Copper – SPX VS Commercial

Nothing too definitive can be drawn here other than a word of caution for the SPX as commercial positions appear to becoming more net long (chart is inverted for comparison sake).