Across the Curve

Opening Thoughts October 29 2008

Prices of Treasury coupon securities have rebounded from the depressed levels attained in late trading yesterday. I can not ascribe the recovery to a particular overnight news story. I surmise  that the decline in equity futures overnight which has erased about ¼ of yesterday’s outsized gains has combined with the expectation of a very accommodative FOMC later today and motivated some bond buyers to place some money at risk,The yield on the benchmark 2 year note has dropped to 1.56 percent, according to Bloomberg. The yield on the benchmark 5 year note has slipped 7 basis points to 2.67 percent. The yield on the benchmark 10 year note has dropped 3 basis points and rests at 3.80 percent and the yield on the Long Bond has edged lower by 2 basis points to 4.17 percent.

The main focus of the financial markets today will be the conclusion of the FOMC meeting and the announcement which the FOMC releases when the participants disperse to the various corners of America.

I think that the FOMC will lower rates by 50 basis points. I also believe that they are prepared to drop rates to levels below 1 percent if the economy continues to falter.

Since they FOMC last met the labor market has deteriorated and consumer confidence and consumption have fallen sharply. Car sales are weakening and business investment has softened.

There is a significant  negative wealth effect at work now as the ongoing declines in home prices have been amplified by the wealth destruction attributable to the crash of the equity market. As the US consumer totes up his assets and future liabilities, he cannot hold an overly optimistic outlook and I suspect that the savings rate will begin to rise placing additional pressure on consumption

The weakness is not confined to the US and the travails elsewhere will reduce exports which have been the only robust sector over the last several quarters.

I will not list the financial headwinds weighing on the economic outlook but they are well known and legion.

Inflation had been a concern of the central bank but the decline in commodity prices should assuage those fears and motivate the assembled policy makers to reduce their emphasis on that economic villain.

If the FOMC adopts such a dovish stance as I suspect they will, I believe that augurs for a much steeper yield curve. The front end of the bond market will benefit from reduced funding levels while the weight of supply will depress longer maturities.

I also believe that reduced consumption in the US can perversely lead to higher rates in the belly of the bond curve. As consumption declines the trade deficit will improve and there will be less dollars sloshing around overseas for recycling back to the US market.

So at the very moment that the US fiscal deficit is exploding, I suspect that a source of demand (foreign central banks) which has been reliable and inflexible for a decade is likely to wane.

Have a great day.

JJJ