Market Commentary

Sovereign debt risk is again at the forefront
April 09, 2010

Sovereign debt risk is again at the forefront.  ECB President Trichet yesterday played down the risk of Greece defaulting.  His statements helped the euro firm but did little for Greek bond yields which now stand at a record spreads.  Treasury prices however were nominally lower suggesting that Greece might not be the issue some fear.

Can I again write there might be other issues affecting the treasury?  Even though initial jobless claims unexpectedly rose last week, recent data on balance has been stronger than consensus.  Perhaps there was some profit taking following a relatively well bid 10-year treasury auction.   .  Or maybe there is something more systemic.

Earlier in the week I wrote there is a strong probability the cyclical bear market in treasuries might become a secular one.  The reasons are well known…uncontrollable deficits and an extremely accommodative Federal Reserve. 

In my view the 10-year could trade to around 4.25%, the area the benchmark stood in June 2008 before the devastating leg in the credit crisis commenced.  If yields decisively break this level, the odds that we have indeed entered a secular treasury bear market rises exponentially.

How will such an increase in treasury yields affect the economy, especially housing?  As widely discussed, the government ceased buying mortgage backed securities on March 31.  The average 30-year mortgage rate is up about 25 basis points since however I think this increase is the result of higher treasury rates.  In fact mortgage backed spreads have narrowed.

In September 2009, 30-year mortgage rates were around 160 basis points over the 10-year treasury, close to the historical average of about 150 bps.  Today they are around 120 basis points.  Can I write the narrowing of spreads is a function of too much money in the economy, an environment that could create inflationary conditions?

The steep yield curve is suggesting yes as such a slope is closely correlated to growth induced inflation.

In my view the longer the Federal Reserve delays in rising the overnight rate, the greater the odds of growing pricing pressures.  The Central Bank is walking an extremely thin tight rope.  Tightening too soon might squelch the recovery.  Tightening too late risks greater future inflationary pressures. 

Commenting briefly about yesterday equity action, stocks rebounded from an early morning Greece induced selloff on first quarter earning optimism.

Last night the foreign markets were up. London was up 0.70%, Paris up 1.22% and Frankfurt up 0.88%.  Japan was up 0.32% and Hang Sang up 1.56%.

The Dow should open nominally higher on speculation that Greece will get an international bailout to avert default.  The 10-year is up 2/32 to yield 3.88%.