Interest Rates: Due for a Pullback?

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While March 30-Year Bond prices climbed to a new 4-week high recently, we feel they are richly priced and vulnerable to a temporary setback. The recent trend of US economic data has shown continued improvement, suggesting that the US recovery could be gaining some momentum. While the US Treasury market will continue to ebb and flow with developments surrounding the European debt debacle, it is possible that the worst of that situation has already been priced into the market. So far in 2012, European debt auctions have gone generally better than expected, and that has helped to thaw short term lending markets in the region. Also, interest rates yields in Italy and Spain have eased from their recent extremes. Those governments have come to the market with new issuance, but so far the market doesn’t appear to be extracting a high cost for their borrowings. One of the market’s primary fears became a reality back on Friday January 13th when Standard and Poor’s downgraded credit ratings on eight European countries, but even that didn’t seem to prompt a typical anxiety event. While that negative headlines generated some safety bids and in turn served to push March Notes above their December highs, March bonds were not able to take out their December highs. Europe’s ability to successfully tap the capital markets could extract some of the fear premium out of the US Treasury market in the coming weeks.

The recent trend of US economic data has provided some hope that the US recovery will begin to stand on its own. The US labor market saw continuing jobless claims fall precipitously from their June 2009 peak of 6.398 million to the lowest level in 13 quarters at 3.657 million as of December 10th. More recently, US June Consumer Confidence climbed to its best level in eight months to 64.5 in December, and manufacturing activity has shown signs of leaving its 2011 summer trough. Additionally, the US housing market has also shown signs of improvement, evidenced by a surge in building permits and construction spending and US housing starts reaching 685,000 in November, their highest level since April 2010. Meanwhile, inflation is beginning to increase, with the December Producer Price Index (excluding food and energy) coming in at an annualized rate of 3.0%, the highest level since June 2009. Coincidentally, there has been a growing chorus of Fed officials that are leaning toward a pro-inflationary stance, as indicated by the continued commitment to extremely low interest rates even in the face of modest inflationary pressures.

While the latest string of US Treasury auctions showed very active participation at extremely low interest rates, there is growing competition from other nations (particularly the Euro zone) as well as from the private sector seeking capital. This could present a challenge in the weeks ahead. If the situation in Europe shows any sign of progress, that could help drive up rates on US Treasuries as they try to attract demand.

March Bonds have traded within a trading of 146-12 to 134-22 over the past four months. The market’s inability to rally to new highs in the wake of the latest European debt downgrade and in the face of recent promises of more easy monetary policy from the US Fed suggests that prices are a bit rich at 145-00.

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