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Kind Of Bearish

The following is the summary lead-in to this week’s Wall Street Examiner Professional Edition Treasury Update. The subscriber link to the full report is below.

A massive wave of panic buying has sent Treasury yields plunging to record lows. Data shows foreign central banks were net sellers in recent weeks, continuing a trend of weakening FCB buying. Under the circumstances, the Treasury panic may not be long for this world, although yields appear to have more downside technically. The target still appears to be around 1.60 on the 10 year Treasury.

FCB Purchases Vs. 10 Year Treasury Performance Chart - Click to enlarge


The previous tight correlation between Treasury yields and FCB buying has broken since April 2011. Treasury prices have continued to rise and yields fall in spite of the reduction in FCB buying. That spread has widened dramatically in August and September. This is unsustainable.

The problem with reduced FCB subsidies for the Treasuries is that levels of new Treasury supply which could once be easily digested by the market present a bigger problem now. Net new supply for the big September 15 settlement appears to be “only” $15-$25 billion. There was a time that the market would have digested that with relative ease. Stocks might have taken a small liquidation hit from that, or stock rallies might have been blunted a bit. That was when FCBs were absorbing 25% of new supply or more, week in and week out. With FCBs actually disgorging some of their Treasury holdings, adding to supply rather than absorbing it, the corollary is that more stock liquidation will be required to absorb the same amount of paper auctioned by the Treasury than was the case in the past.

I have covered, in the Fed Report, the case for believing that the Treasury rally is driven largely by the panic flight of capital from European banks and bank paper. This in turn has led to short covering of Treasuries and margin calls on Treasury shorts, which in turn has resulted in selling of equities. The lower yields go, the more this trend will be exacerbated. Falling yields also have a psychological effect in sending the message that they signal a weakening economy. That triggers more selling of equities and buying of Treasuries in a vicious cycle.

So a 1.60 yield on the 10 year, assuming we get there, could be incredibly bad news for the stock market. In the July-August plunge, the S&P lost about 2 points for every basis point that the 10 year yield dropped. If that ratio holds up and yields reach that target area of 1.60, the SPX would have a hypothetical target of around 1035.

Naturally, there’s no guarantee that yields will make it that low, or that if they do, the correlation will remain the same, but things are heading in that direction. Increasing Treasury supply without the buying support of FCBs could slow or finally reverse the decline in yields, especially at the end of September, with the next round of note sales. At that point stocks could continue to do worse, as the Primary Dealers and others would need to liquidate more equities to absorb constantly increasing waves of Treasury supply. The additional tax cuts proposed in the new “jobbed” bill will only exacerbate the supply problem in the short run. So, in case I didn’t make myself clear, I guess I’m kind of bearish. DOH!!

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