Farrell: Tug of War

There is a tidal wave of government bondscoming to market the next few years. Estimates are for $2 trillion a year for at least the next two years. So on the one side of the pit over which a good tug of war is waged is the Treasury offering a ton of bonds for sale. On the other side is the Federal Reserve offering to buy $300 billion of that debt in the hope that it will keep interest rates down. Doesn't sound like a fair fight. But there is also, according to Nobel laureate Paul Klugman, a "global savings glut" that has no alternative but to buy U.S.Treasury paper.

I hope so but the recent weakness of the dollarunnerves me and who says this savings glut has to/wants to/needs to buy U.S. debt except if the price is very right. There is, in my opinion, no good and ready alternative to the dollar prepared to function as the world's reserve currency, but that doesn't mean our debt will be financed at low interest rates.

The bond market went on a crazy ride last week with the yield on the 10 year bond moving from 3.53% to 3.73% (a huge move in the bond market) only to retrace itself and go below where it started and finish the week around 3.45%. And all of that in the space of just two days! A lot had to do with bond managers balancing the duration of their portfolios combining mortgage bonds with a long or short position in Treasuries. That will sort itself out but the yield on the ten year has moved from 2.06% at the end of 2008 to the current 3.45%. Rising Treasury yields, along with firming commodity prices - oil is up over 100% from its low to the current price of $66 and the Reuters-Jeffries Commodity Index was up 14% last week, the largest weekly advance since July of 1974- usually indicates an improving economy. The economy is absolutely improving but Joshua Shapiro of MFR put it aptly when he wrote that there is a "considerable difference between avoiding calamity and enjoying recovery." Remember that so much of the news has been "less bad" as opposed to outright good.

Lacy Hunt of Hoisington Investment Management wrote recently that a "sharp rise in Treasuries isn't the result of an economic recovery. That occurs when income, production, employment, and sales turn simultaneously higher. Presently these indicators show a lessened rate of decline." We will get the chance to see if any of these will turn further to the good with this week's helping of statistics.

Early Monday we get the latest Institute of Supply Management report. This is where the breakeven between expansion and contraction is 50. A reading of 42 is predicted due at least in part to the shutdown of auto production. Wednesday sees the ISM non manufacturing index which is in a sense bigger as it represents more of the output and its reading is expected to still be a contractionary 45. The critical jobs number is Friday along with the unemployment rate which is sure to top 9%.

With a 10 year and a 30 year bond auction on tap, the confusing bond market, and the glut of significant news to be reported, one should be cautious. On the other hand (and Truman always wanted a one-armed economist so he could get a single opinion) the stock market took a lot of bad news last week and did well. When markets don't go down on bad news (Friday's Chicago Purchasing Managers Indexwas particularly ugly, and the market went up) that is itself the good news.

I continue to feel the back up in bond yields is due more to the supply issue than it is to an improving economy so I would still be careful out there.