ODJ Debt Futures Review: Long End Suffers As Yield Curve Steepens
-- Greenspan's Speech Prompts Selling In Long End While Losses In Short End Of Curve Are Limited
-- Fed Chairman Signals Policy-Setters Would Be Willing To Trim Rates Again But Likely Won't Use Unconventional Easing
-- Technical, Mortgage-Related Selling Exacerbate Declines
By Allen Sykora
Chicago, July 15 (OsterDowJones) - Debt futures in the long end of the yield curve took a pounding after Federal Reserve Chairman Alan Greenspan's testimony on monetary policy before the House Financial Services Committee Tuesday.
The short end of the curve held up much better, finishing with more modest losses. Analysts said traders were putting on steepening trades - which favor the front end over the long end - after concluding that policy-setters would be more likely to trim the federal-funds rate again than turn to unconventional easing such as buying Treasuries, should economic weakness persist.
Also hurting the long end, sources said, were ideas that Greenspan did not appear overly concerned about the prospects for deflation. Also limiting the losses in the front end, they said, were the chairman's comments that the Fed would try to hold down interest rates for as long as possible.
The market was also hurt by stronger-than-expected economic data before Greenspan began talking, as well as worries about the growing deficit following updated budget estimates from the U.S. Treasury.
Several factors accelerated the declines in the long end of the curve, including technically oriented selling, with sell stops being triggered. Also, the rise in yields forced mortgage-related accounts into convexity selling.
"There was a lot of volume and it was a crazy day," said Roseanne Briggen, market analyst with MCM.
Sep 10-year notes settled down one full point plus 13.5 ticks to 115-00.5, while Sep bonds lost two full points plus 7 ticks to 112-15. Dec eurodollars fell just 3 basis points to 98.855.
"Clearly, this is all about Greenspan," said Briggen. "The front end is weaker, but not as weak as the long end. Everybody is putting on a steepening trade.
"He was very candid and there was no guesswork in this testimony. He made it clear there is room for more easing and dispelled the myth that everyone was thinking - that fed funds can't go below three-quarters (of a percent)."
Briggen commented that Greenspan's prepared text suggested policy-setters would continue to use conventional easing, namely cutting the fed funds rate, if necessary. Greenspan also suggested that the possibility of using unconventional forms of easing was remote, Briggen continued.
"Everybody had been thinking he would keep the front-end rates steady and buy long bonds and 10-year notes to lower long-term rates," said the analyst.
As did other analysts earlier today, Briggen also cited as bearish Greenspan's comment in the question-and-answer session that he was not surprised that 10-year yields have been climbing since the Fed opted to trim by just 25 basis points last month.
"What that did was squash any hopes at all they are going to make an effort to keep long-term rates down," Briggen said. "With that in mind, the curve should steepen further."
The yield on 10-year notes, which moves inversely to the price, has risen from a June 16 low of 3.07% to a 2 1/2-month high today of 3.968%.
Some selling in the longer end of the curve resulted when Greenspan was not able to comfort the market on why policy-setters trimmed by only 25 basis points last month, when many traders had been expecting a half-point cut, said Lara Akin, financial futures analyst with Refco.com.
"They (traders) are not really buying this disinflation talk any more," she continued. "Greenspan did mention it, but it was all the way at the end of his speech.
"He tried to keep the same tone as before (when Fed officials suggested deflation was a possibility), but after that 25-basis-point rate cut, people aren't buying it."
The declines in the long end of the curve were compounded when key technical levels were broken, with "black-box" traders and technicians getting sell signals.
"Then you have the mortgage guys really in a pickle because they have to hedge their convexity all the time," said Briggen. "When (market-set) rates rise this quickly, they've got to sell. So they've been adding to the pressure."
The nearby eurodollars held up thanks to the portion of Greenspan's remarks in which he said the Fed would keep interest rates low "as long as needed," sources said.
"The eurodollar market has decided Greenspan is not lying when he says the Fed is going to keep interest rates on hold," said Akin.
More deferred eurodollars were hit hard, however. For instance, while the Mar 2004 contract was losing 6 basis points, the Mar 2007 contract tumbled by 29.5 basis points. That's because there are doubts that rates will still be on hold a couple of years from now as the markets start factoring in economic improvement, explained Akin.
"The markets aren't going to let the Fed keep interest rates on hold at 1% (for the federal-funds rate) for two years," she said. "Nobody is happy with that except for the banks."
Stronger economic data ahead of Greenspan's speech also dampened market sentiment for the long end of the curve, sources added.
June retail sales rose 0.5%, when expectations had been for a 0.4% rise. Sales excluding autos were up 0.7%, when forecasts had been for a 0.3% or 0.4% increase.
Also, the New York Fed's Empire State Manufacturing Survey was stronger than anticipated, even though it did decline from last month. The headline reading for July was 22.6, down from 27.6 in June but above the 15 reading expected by economists.
"The other thing that added to the pressure in the long end was the budget- deficit news," said Briggen. "It was much higher than expected."
And that, in turn, prompted some speculation that perhaps the Treasury will eventually resume issuing 30-year bonds, said Briggen. This was especially the case after last week's resignation by Treasury Undersecretary for Domestic Finance Peter Fisher.
The Treasury projected that this year's federal deficit will surge to a record $455 billion and that next year's budget shortfall will hit $475 billion.
Technically, some support for Sep 10-year notes may lie around 114-22, after the market held after moving a single tick below this, said Akin. More substantive support can be expected at 113-04. Resistance was projected at 115- 18.
In Dec eurodollars, she put support at 98.83 and resistance at 98.90.
Greenspan is to testify again Wednesday before the Senate Banking Committee at 0900 CT (1400 GMT). The main economic reports for the day will be the Consumer Price Index at 0730 CT (1230 GMT) and industrial production at 0815 CT (1315 GMT).
The CPI is expected to be up 0.2% in June, while core CPI excluding food and energy is forecast to be up 0.1%. Industrial production is forecast to be steady or rise 0.1%, while capacity utilization is projected to hold at 74.3% or else inch up to 74.4%.
