10 yr treasury and S&P correlation

As is visible on this chart, the bullish breakthrough of the 10 yr note 112 price area in early November coincided with the latest spat of CDO writedowns. The correlation was pretty obviously inverse to equities.

Note how we've also been pivoting around 1485-1490 in the S&P cash for the last several months. Right now the 10 yr note futures are sitting at 113, (112'080 or so on the March 08 contract). A convincing upside breakout in equities will make notes appear to be a sell. This is why I suggest buying note calls, and likewise buying equity calls and stock here. The calls build in your stop loss to what looks to be a good entry in a bullish bond market.

Its always amusing of key inversely correlated markets tend to pivot around the key support and resistance points simultaneously. In this case, 112 for 10 yr notes and 1525 for equities.

Treasury Positioning, Housing & Commodity Based Inflation

Making a trade based on yields always makes me reflect on a broader economic picture. Since all developed nation fixed income yields are correlated to some extent, a discussion of US treasury yields is also a discussion about everything else. Inflation correlations, both wage and commodity driven, can not be avoided. At the center of this discussion is the realization that the digestion of a speculative blowoff top in housing does not present the biggest vulnerability to global economic growth in real terms. It is commodity price inflation.

While the housing downturn has taken a gigantic hit to bank balance sheets and credit market stability, the question remains unanswered how much the global economy is dependent on the levered consumer with little free cash flow. I will not attempt to answer that, simply because it is beyond my scope, since I do not possess Nostradomus' predictive talents.

Starting with the trade to take, Friday's somewhat non-cataclysmic jobs report saw a recovery of yields by 10 basis points on long duration treasuries.

Here are the December 07 treasury yields as per the US treasury website.




With short term money getting bid so high, it is pretty clear there remains quite a few points of upside in the treasury rally. A santa clause rally in equities provides an obvious dip buying opportunity in a bond bull. One doesn't need to look to hard to find that the equities markets do statistically pretty well for the next 30-45 days this time of year.

Unless some foreign buyer comes in and buys up the existing new and resale home inventories to support the housing market, the pressure on equities isn't likely over. Additionally, those betting on a recession are likely betting on an inversion of the yield curve, at least in the short term. This too is supportive of treasury yields. Thus I conclude the flight to quality trade is not over.

Furthermore as evidenced by my past discussion on shorting the Canadian dollar, any weak dollar concerns did not show their face in the treasury market. This was a clue to buy the dollar. Furthermore, a weak dollar viewed as having upside should be supportive for any US dollar assets going forward. That means equities as well as treasuries, even at these ridiculously low yield levels (for treasuries).

Since equities are above key technical support in the major US indexes (1490 being that level in the S&P 500), it may be wise to buy January equities calls now while simultaneously scaling into US treasury bond and note calls over the next 30 days. As long as equities are doing well, treasuries will likely have downward pressure. At worst one trade will likely offset the other. Its a hedged trade that may have positive results on both sides, depending on the time frame of each. With other central banks cutting rates, a dollar panic leading to a run on treasuries is the most unlikely predicament of treasuries being unsupported.

I can think of plenty of reasons on the long term to short treasuries - namely commodity based inflation pressure that is function of the weak dollar and poor US energy policy, the probability that a recession does not occur and the US is past the worst of the housing bubble collapse, and most importantly the possible flight away from US assets by petrodollar and Asian reserve holders as the US continues to embark on lousy policy decisions.

Past housing cycles have taken many more years to bottom and flatten than the 2 years we are in to this. While previous housing corrections have coincided clearly with recessions, they also did not coincide with a credit bubble. The collusion of ratings agencies with CDO issuers to even enable the subprime buyer into the housing market did not exist in past housing booms.

Right now we are suffering the effects of typically overlevered banks having to pay the piper for poorly done initial CDO asset valuation models. But we have not yet gone into recession, the consumer has not stopped, nor has the jobs market shown any real signs of weakness.

The fundamental question remains: Does the problem end here, with banks and investment houses counting their losses, or do we proceed to the next typical step in economic cycles?

Considering that housing bear markets take a lot longer to play out due to liquidity characteristics (low trading volume), I say we are in for more downside. More price corrections are ahead, as well as consumer spending contagion into the rest of the economy. As illustrated in this New York Times chart, the last 2 previous housing runups with less volatility took at least 7-10 years to return back to peak levels. Note this chart's recent parabolic move is likely accentuated by Schiller using a CPI calculation with parameters that changed during the Clinton era. Most recent inflation numbers are higher, and should flatten this parabola considerably. The speculative component remains accentuated by the unprecedented inclusion of subprime buyers to bid the market up late in the cycle.



Ignoring the fact that often highly volatile moves often have just as volatile reversals, it is not overly pessimistic to conclude housing will not bounce back for another 5 to 10 years. Moreover, due to a possibility that subprime buyers may not be in the market to bid up prices, it may not return to highs until possibly the cycle after next. If history repeats itself, that should be 25 years from now. On the other hand, if US policy of dollar devaluation continues accelerating as it has, then a return to highs is likely sooner than 25 years.

I view housing prices as having two primary components to determine value: intrinsic(defined by value of the goods and labor to build the home and procure the land, a function of inflation and USD value), and speculative. The intrinsic component (weakening dollar and more importantly more expensive commodity costs) should act as a support to prices. When it costs more to build a house than to sell it, the new home builders will simply stop building. Furthermore, when rents approach the cost of holding a typical 20% down, 30 year fixed mortgage on an equivilent property, home prices will find support. Upon a bear market, this will define the price floor as the speculative premium dissippates.

With all of that considered, the FOMC and US policymakers should count their blessings that the flight to quality in long duration treasury assets is keeping yields near all time lows. Just imagine how this current housing market would deal with historically normal 8% mortgage rates for top quality conforming buyers? Or better yet 10-12% rates, more typical in past years of inflationary upticks.

I have had the most difficulty reconciling the fact inflationary pressures are being completely ignored by the developed world's bond yields. With oil and gold near inflation indexed highs, one would think they would be accompanied with high yields, typical of investors wanting return on their investment to offset annual losses to inflation!

With supply and demand margins thin on plenty of commodities, it is inevitable that eventually free cash will be squeezed away from consumer spending on unnecessary items first, then more necessary ones (the commodities themselves). First you buy less Ipods, then you drive and eat less. It seems the mature bond markets are already betting on slowed consumption unnecessary items, as a flattening yield curve tells. Perhaps the next step is a yield curve inversion coinciding with falling commodity prices and recession confirmation.

With copper prices as well as drybulk shipping rates currently falling, one can only think that this may be a tell that perhaps this cycle of the world growth story is coming to an end. This may be driven by emerging markets such as China not being able to deal well with the recent ascent in crude price. The cost of energy in these emerging markets is rapidly slowing economic growth. In China, fuel at $2.25 per gallon or pork at 90 cents US per pound doesn't bode well with the average Chinese consumer and business owner.

Assuming they are partially reflective of supply/demand fundamentals, and not purely speculative fund flows, current crude oil prices are sustainable without having a massive impact on the developed market consumer. The fact that the consumer is enduring is a testament to increased business productivity and overall economic efficiency that has resulted from technological innovation in computers, communication, and the Internet during the last twenty years.

This progress in technological innovation may have raised the ceiling on what we can endure for energy input costs from maybe $50/barrel to an arbitrary number such as $200/barrel. There is a price, however, where the consumer will dramatically cut consumption, and recession will be inevitable.

While China's recession-inducing crude price ceiling is likely considerably lower than $200/barrel, it is likely one of the only factors keeping oil price down in the short term. Imagine what would happen to oil and commodity price if China let their currency float as US and EU policymakers demanded? Chinese buying power would increase instantly, and their commodity input cost savings would likely help Chinese exporters absorb the negative demand from increased export prices. It is arguable that the developed world would merely shift their economic weakness from their exporters into a more broad hyperinflationary commodity-driven cost of living increase for all.

The Bush administration should look at this most recent crude oil price ascent to nearly $100/barrel as a reflection of failure of crude price-driven foreign policy because it was inspired not by a black swan terrorist event but by normal supply/demand and speculative market dynamics. Productivity increases and dollar devaluation made the milestone less meaningful from an economic perspective. But there will be a price that is devastating to the world economy; the markets just gave a tell that it won't take much to get it there. This all makes the point that all of the strategic positioning in the Middle East and trillions of dollars spent are simply maintaining the status quo.

Besides a deep global recession, the only way out of this commodity based inflationary pressure is an aggressive commodity/energy policy such as increasing fuel effiency standards within 3 years, not 13; a massive buildout of cost effective energy sources, whether it be primarily nuclear, solar or wind to facilitate a move to for all new vehicles to primary become electric and hybrid electric/gasoline operated; and removal of corn ethanol subsidies to give back acreage to other highly demanded and supply deficient crops as wheat and soybeans.

These are just a few ideas on how to solve the problem. Please post your ideas here. In the meanwhile, buy some treasuries.