So Long to the Long Bond
The Treasury Department gave new meaning to the Halloween tradition of trick-or-treating. Our market contacts say it royally tricked many a trader, while potentially treating some on the BMA (privy to inside information?) when it announced, prematurely we might add, that it was eliminating the venerable long bond. Despite the fact the Treasury says it is not a "market timer," the Treasury's timing certainly smelled of that, especially as it achieved what neither Treasury jawboning nor Fed rate cuts could -- bring down long term yields. And, the key question at this point is whether this potential stimulus from the Treasury will put the Fed on a less aggressive (25 basis points) course on November 6.
That the long bond was probably on its way out was not a surprise, but the fact that the Treasury gave some an early read on announcement dishonored the notion of "full faith and backing" of the U.S. government. News that the Treasury website leaked information that long bond would be eliminated spread quickly through the pits and trading floors. Bonds were thus already jumping before the "official" 10:00 EST announcement. But worse than that leak, many of our contacts were highly critical of the BMA's insider information pertaining to the Treasury's plans. They note that though data have certainly been bullish, the long bond made and sustained significant gains over the past five days. They also harkened back to the "surprise" reopening of the 10-year notes in conjunction with the repo fails post September 11, and noted unusual buying activity in the market just prior to the announcement.
The better than five-point move on the long bond (the second largest percent change in history), the concomitant 35 basis point drop in yield to the 4.80% area, and the severe 40 basis point flattening in the coupon curve from +275 basis points to +235 basis points obviously was a boon to traders long the bond. But it crushed the market makers who had taken the other side of the trade, as well as those who had put on steepening trades in expectation of another aggressive half point cut from the FOMC Tuesday.
Treasury undersecretary Fisher defended the bond's elimination in a CNBC interview, saying that it was done entirely on the basis of the government's expected financing needs. He reiterated that the Treasury was "not trying to outsmart the market," though he acknowledged that government financing would be focused on the shorter maturities, designed to save taxpayers money. Fisher said that this shift was based on the assumption that deficits in 2002 and 2003 would be followed by surpluses again as the economy recovered, revenues streamed in and the government's emergency spending measures tapered off. Should those assumptions prove erroneous, the Treasury would find it "cost free" to revive the bond, he said -- comments no doubt that will ring hollow to those who were pummelled by his department's actions.
In terms of Fed policy, the drop in the yield on the long bond will likely cause a refinancing boom the likes we've yet to see. The extra monetary stimulus it should engender could leave the FOMC on a less aggressive track when it meets on November 6. Much weaker than expected data on retail sales, durable goods and consumer sentiment had upped the risk for such to about 55% to 60%. But it may now take a very frightening NAPM and payroll reports, if that, to revive that call.