At the Mercy of the Bond Market

As the yield on the 10-year U.S. Treasury note shot up by 28 basis points in the past two weeks, its effects immediately spilled across the border by bumping up interest rates in Canada

ALEX ROSLIN
SPECIAL TO THE GAZETTE
Monday, May 28, 2007
The Montreal Gazette

Start talking about bonds with most people, and they’ll probably want a siesta.

Not Mark McClellan. He’s a bond expert at Montreal-based BCA Research, and what he sees in the bond market has him wide awake.

Bond action tends to herald what’s in store for other markets—everything from home sales to gas prices, the stock market and the Canadian dollar.

So when the yield on the trend-setting 10-year U.S. Treasury note broke out of a narrow trading range and shot up 28 basis points in the last two weeks, McClellan and lots of folks on Wall and Bay Sts. paid close attention. (A basis point is one-hundredth of a percentage point.)

“There was quite a capitulation,” McClellan said. “Technically, it was pretty impressive.”

The yield rose to just under 4.9 per cent last week, up from 4.4 per cent in December.

Lenders in the U.S. and Canada closely follow the 10-year Treasury note as they set interest rates.

The U.S. bond action immediately spilled across the border, bumping Canadian consumer interest rates higher and bond prices down. (When rates go up, bond prices fall.)

In mid-May, a key Canadian bond fund, the iUnits Canadian Bond Broad Market Index Fund, suffered a serious blow when it broke below a key psychological level of support that had buoyed its price since last October.

The question now is whether the sharp and sudden spike in interest rates is just a blip or something more worrisome.

McClellan said he’s not worried—at least, not just yet. “The market has revised up growth expectations,” he said.

“Strong growth and low inflation are a positive environment for the equity market. But if people start worrying about inflation, that would change.”

In fact, far from knee-capping equities, the Treasury’s move may just mean money is pouring out of safe-haven bonds into the roaring stock market, said Mark Arbeter, chief market technician at Standard & Poor’s Equity Research in New York.

“Probably what’s happening is that money is going from bonds to stocks because of the recent advances,” said Arbeter.

“Probably it means stocks are going higher, as perverse as it sounds.”

The problem will come, he said, if interest rates keep going up.

“That would hurt equities,” said Arbeter.

He and McClellan agreed a key test will come at 4.9 per cent, the Treasury note’s previous high of last January.

The yield made a run at 4.9 per cent last week, and if it blows past that number, both analysts warned of further interest-rate rises and storm clouds for other markets.

“If it gets above 4.9 per cent, it would be a bad sign for equities,” McClellan said, saying that would suggest growing fears about inflation.

“Keep an eye on inflation expectations if it gets above 4.9,” he said.

Arbeter thinks that’s just what will happen and predicts the 10-year yield will shoot up to 5.5 per cent. He pointed to action in the futures and options markets as a sign the recent bond move may have legs.

Large commercial firms that hedge in bond derivatives turned highly bearish on the 10-year Treasury note in March. These traders, whom Arbeter calls the “smart money,” tend to time the markets with uncanny accuracy.
When they sour on a market, watch out.

Arbeter said the commercial traders’ bond holdings suggest lots of institutional money is behind the Treasury move.

The rate jump may already be translating into weakness in commodities. The price of gold, which tends to lead other commodities, suffered a breakdown in May, ending a seven-month uptrend that had shot it from $563 U.S. last October to $698 in April.

At bullion dealer Kitco, analyst Jon Nadler said sentiment is gloomy.

“The mood is bearish (for gold),” he said. “Bond yields breaking out could add to the current woes. (Gold) now looks to correct.”

Arbeter agreed that higher bond yields could inflict pain on commodities while helping revive the sickly U.S. dollar, which has nose-dived vs. the loonie since March.

“It could lead to a breakout (in the greenback) or at least to stopping the bleeding,” he said.

Alex Roslin’s market blog is at http://cotstimer.blogspot.com

[Accompanying charts for this story showed the breakouts in the 10-year and 30-year Treasury yields, the breakdown in the iUnits Canadian bond ETF (symbol XBB) and the recent breakdown in the gold price.]