Breakfast With Dave_052809

David A. Rosenberg Chief Economist & Strategist [email protected] + 1 416 681 8919

May 28, 2009 Economics Commentary

MARKET MUSINGS & DATA DECIPHERING

Breakfast with Dave WHILE YOU WERE SLEEPING No earth-shattering events to speak of today. Economic data overseas were mixed:

IN THIS ISSUE • Lots of data action in the U.S. today; durable goods, initial jobless claims, new home sales

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German unemployment fell only 1k in May (consensus was 64k) but machinery orders tumbled 58% YoY for April.

•

EMU consumer sentiment diffusion index came in below consensus, at -31, for May (consensus was -30) and the comparable for business sentiment was -34 (consensus at -32).

• Are we seeing the buying opportunity of the year in bonds?

•

The UN reported that per capita world income will decline 3.7% this year – we have no clue how that can possibly be bearish for conservative investment strategies.

• What about the equity markets? We suspect that the nearby peak was May 8

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New Zealand was given an upgrade to its credit outlook by S&P. (Yes, the rating agencies can go in both directions, even when it comes to government rankings.)

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On the markets, it’s mixed in Asia (the Nikkei and the Kospi up, but Australia, New Zealand and Singapore down) and European marts are off nearly 1%.

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The yen is softer on the FX market as is oil on the commodity market (though OPEC has already signalled that it would not mind seeing the price of crude in a $75-80/bbl range). The fact that the Baltic Dry Index surged 7.6% yesterday and broke above the 3,000 mark for the first time since last October is a signpost that the commodity market recovery is not over.

•

Bonds in Europe are following yesterday’s U.S. rout, though Treasuries are staging a bit of a comeback this morning. The pundits all talk about Treasury supply and yet here we have the junk bond market expanding by $15 billion in terms of new supply in May, which was the largest since last October; and investors seem keen on chasing performance because this sector has delivered a 25% total return year-to-date.

• No greenery in the housing market

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May 28, 2009 – BREAKFAST WITH DAVE

DATA ACTION IN THE U.S. As for the day-ahead, we have U.S. durable goods new orders at 8:30 a.m. — the consensus is looking for a 0.5% MoM bounce in new orders in April reversing some of the 0.8% decline seen in February. Excluding transports, new orders is seen coming in at -0.3% in April, a slightly better performance than the revised 0.7% MoM registered in March. Initial claims for the week ending May 23 come out at the same time, and they are widely seen coming in at 628k from 631k the prior week. Continuing claims are expected to rise to 6.745 million during the week of May 16 from 6.662 million the prior week. Then at 10 a.m., new home sales data are released and the consensus is looking for sales to come in at 360k in April, a 1.1% MoM increase from March’s level. Keep an eye on the unsold inventory (was 10.7 months’ supply in March — needs to dip below 8.0 months’ supply before home prices bottom out).

Busy data day in the U.S.

BUYING OPPORTUNITY OF THE YEAR IN BONDS? Okay, the gloves are off. Just as was the case in the summer of 2007, the bond bears are coming back out of hibernation, and we see and hear that they have a new set of pencils and rulers out and declaring, yet again, the end of the secular bull market in Treasuries. Not so fast. Yes, the 10-year T-note yield surged another 18 basis points yesterday to 3.72% (the long bond is now at 4.63%) and in a mere four trading sessions, has jumped 59 basis points. The chatter is all about supply, supply, supply, but is that really new news? For a second day in a row, we actually had a decent showing at a Treasury auction (the yield coming in at 2.31% versus pretender expectations of 2.335%; a bid-cover ratio of 2.32x compared to an average of 2.17x over the prior 10 auctions; indirect bidding — proxy for foreign central bank involvement — came in at 44.2%, well above the average of 32.4% of the previous 10 sales).

The bond bears are coming back out of hibernation, but not so fast, this secular bull market in Treasuries is likely not over

There wasn’t much of a ‘green shoot’ at all in the existing home sales data (see below), and even the beleaguered U.S. dollar managed to rally seventenths of a tick to the 80.8 level. As we showed yesterday from the Conference Board data, negative sentiment on the bond market has hit extreme levels that in the past touched off solid rallies for the few brave souls that dipped their toes into the market as everyone else exited the pool. Here is what we know: 1. The last time we had a condition like this was from October 8 to October 15 of last year — the 10-year T-note yield spiked from 3.4% to 4.1%. A month later, it was sitting at 3.6% — three-quarters of the selloff was reversed. 2.

The Fed has conducted 24 bond sales covering $130 billion. That leaves $170 billion left in its arsenal and it notified us at the last meeting that it could well boost its quantitative easing program.

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May 28, 2009 – BREAKFAST WITH DAVE

3.

And why wouldn’t it? It’s one thing to have a Treasury yield backup when mortgage rates are still declining, but that is no longer the case. The yield on the 30-year fixed-rate is already up 20 basis points from the lows; 1year ARMs have jumped 17bps. This is not what the Fed wants to see.

4.

There is no evidence from the custodial data at the Fed that central banks are cutting back on their exposure to Treasury securities.

5.

The inflation rate is now -0.7% YoY and set to approach -2.0% during the summer for the first time in six decades. A near 6% real yield potential looks pretty attractive — we haven’t seen that in a good 25 years.

6.

The yield curve (2s/10s) has massively steepened to 275bps. This is unsustainable and is going to flatten but the question is how? Will it be by the Fed raising rates and taking away the carry? With the unemployment rate heading above 10%, hardly likely. The output gap is so big that the funds rate, in theory, should be closer to -5% than 0%. So which entity is going to be the one that starts to take advantage of this massive ‘carry trade’?

The banks, that’s who. They are the ones with the cash — over $1 trillion on the balance sheet, which is not only a record but more than triple what was considered a normal level in the past. At the same time, even with private sector borrowing on the decline, the commercial banks have not added anything — nada — to their cache of Treasury securities this year. But, it’s one thing to have the curve at 170bps as it was four months ago and the huge 275bps spread the market is offering today. The banks have never before had so much cash to be put to work in the most attractive carry trade in Treasuries in recorded history.

The last time the 2s/10s spread was this steep was in August 2003 …

… So, who’s going to take advantage of this massive carry trade?

Also note that the last time the yield curve was this steep (again, 2s/10s) was back in August 2003 — the difference, of course, is that the recession was already over and done with for nearly two years; and we were on the precipice of a 4%+ real GDP growth trajectory over the ensuing year. Even so, the curve was not sustainable back then any more than it is today; the Fed was on hold for another 10 months; and guess what, the 10-year note yield rallied 70bps to 3.9% the very next month. We think that this sharp correction in Treasuries (4.5% loss so far this year) started off as a flight-out-of-safety when the Obama economics team put a floor under the financials, then the second stage were the ‘green shoots’, followed by recurring asset mix rebalancing, and then by talk and technicals — the exact stage when the blowoff occurs; and the blowoff is what provides the opportunity.

The banks, that’s who

Let’s not forget what the upcoming round of data releases are going to look like after GM declares bankruptcy — jobless claims are likely going to test the old highs, ISM the old lows, and the boom in consumer confidence is going to seem like a distant memory by Labour Day.

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May 28, 2009 – BREAKFAST WITH DAVE

WHAT ABOUT THE EQUITY MARKET? Well, we have a sneaking suspicion that the nearby peak was May 8 when the yield on the 10-year T-note was 3.29%. That was the tipping point for the stock market, which has only done backing and filling ever since; and some wild swings (three triple-digit up Dow sessions; four triple-digit down days). We would have to think that a 4.63% yield compares quite favourably with a 2.6% S&P 500 dividend yield — the spread hasn’t been that wide in at least eight months. Not only that, but the stock market has become increasingly “less cheap” — over the last six months, 2009 consensus earnings estimates have been pared from +30% growth expectations to a mere +9%. The S&P 500 is trading at multiples of around 17-18x, which is no bargain in our view. Keep in mind that the S&P 500 and the Dow are back to January 12th levels. At that time, the bond market offered very little in the way of any serious competition as the 10-year T-note yield was sitting at 2.3%. Now the same levels of the stock market are competing with a 3.72% yield. NO GREENERY IN THE HOUSING MARKET That 2.9% MoM rise in existing home sales in April to 4.68 million units (annual rate) was a tad flattering seeing as March was revised down, but this followed a 3.4% decline, which followed a 4.9% February surge which, in turn, followed a 5.3% slide in January. Like the stock market, lots of backing and filling and what we are left with is a flat trend. Maybe that is a good sign that sales are forming a bottom, but wouldn’t one expect a lot more than that considering where mortgage rates are, not to mention the $8,000 tax credit for first-time home buyers.

Months’ supply of existing homes rose to 10.2 in April, the high water mark of the year

Not only that, but distressed sales made up 45% of the sales tally last month, so the underlying pace is actually much softer than the headline suggests. But the only figure that matters for us — from a pricing standpoint — is the inventory number; and the news here was not good — rising to 10.2 months’ supply from 9.6 in March, not to mention the high-water mark of the year. The unsold condo supply is north of 15 months’ supply — this is very deflationary for the sector (prices in this sector have deflated 18.5% YoY and there is surely more to come).

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May 28, 2009 – BREAKFAST WITH DAVE

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