With your host Hank Cunningham
Harry Koza's Weekly Column
January 2, 2007
Head for bonds before U.S. MEWers begin to mewl
The new year looms, bringing with it the annual compulsion to pass judgment on the year just ending and prognosticate on the one about to begin. Last year at this time, I predicted a few (three) more interest rate increases (the Bernanke Fed finally stopped raising rates in August, after four rate hikes), discounted the possibility of the inverted U.S. yield curve heralding an imminent recession, and looked for further flattening in the Canada yield curve.
I also predicted further weakness in the U.S. dollar and perspicaciously avoided forecasting that the loonie would be at parity with the greenback by the end of this year, unlike many of the Street's dismal scientists. I also predicted that long bonds, then approaching the 4-per-cent yield level, didn't have much room for further gains.
So far, so good: both the Federal Reserve and the Bank of Canada have both stopped raising rates. The Canada curve -- or the difference in yield -- between two-year and 30-year bonds flattened from 22 basis points at the end of 2005 to 11 now. Canada 30-year bonds were yielding 4.029 per cent last December, and closed yesterday at 4.14 per cent, although they were yielding less than 4 per cent briefly a few weeks back.
Spreads between U.S. Treasuries and Government of Canada bonds continued to tighten, with two-year Canadas moving from 55.5 basis points less than two-year Treasuries to 78.6 beeps less, and 10 years from minus 42 beeps to minus 61.8. The loonie, which closed last year at $1.1646 against the U.S. dollar, briefly peeked below the $1.10 level in May/June this year, but is heading into 2007 back -- as I write this -- at $1.1640, not much changed.
What about this year, if you're so smart, you ask? It's a tough call. Many of the same potential influences on the direction of rates I mentioned last year are still in play: There may be a federal election in Canada in 2007; Iran is still working on getting a nuke; the U.S. housing market has cracked; U.S. consumers are more tapped out than ever; oil prices are just as vulnerable to supply shocks from terrorism or natural disasters.
But, all those possible exogenous events aside, 2007 will be the year to hold your nose and buy bonds. Sure, yields suck. But the ocean of global liquidity that has been compressing credit spreads and driving every market higher (the source of former Fed chairman Alan Greenspan's famous conundrum) is still a major factor in the market, and corporate and government borrowing requirements continue to shrink -- although just how ephemeral this current passion for fiscal probity turns out to be is still to be revealed. (If you think that the days of big deficits and growing government debt are gone forever, then consider these three words: National Daycare Program.)
So, tons of cash looking for returns and fewer bonds available to buy -- you've gotta be long. Much as I have difficulty perceiving 30-year Canadas trading with a three-handle (that's a 3-per-cent yield) as any kind of decent value, at least for individual yield-pigs like me, you can't push the river. Long bonds at 4.15 per cent today will generate fat profits for traders at, say, 3.75.
That's not such a stretch, either. While I hesitate to mention the R-word, I already see economic forecasts of below 1-per-cent annual growth in Canada for the fourth quarter of 2006, and the U.S. economy looks vulnerable. Sure, there have been a few surprisingly strong housing numbers lately out of the U.S., and I could fill several columns with scary statistics and argue on the one hand and on the other hand about the U.S. housing market and whether it has bottomed or only just started its correction.
But in summary, U.S. households are more leveraged than they have been in 50 years, have less liquidity than they have had in 50 years, and are faced with their largest single asset (their houses) falling in value.
Remember all the consumer spending that's been driving the U.S. economy over the past few years? That was financed with what economists liked to call MEW (for mortgage equity withdrawal). Well, I predict that the U.S. consumer will move from MEWing to mewling next year. That suggests slow growth or even a decline in the U.S. economy, with the usual knock-on effects here in Canada, which means that the next likely move in interest rates will be lower. In fact, the next moves by both the Fed and the Bank of Canada will likely be to cut interest rates.
Slowing North American economic growth in 2007 leading to lower interest rates is pretty much the current consensus in the bond market. The Street is fairly sanguine about the U.S. housing market at the moment, but I think that the "pain trade" this year will be in U.S. house prices, and that that market is still quite a ways from the bottom. Using today's yields, the handy calculator at politicalcalculations.blogspot.com puts the probability of a recession in the United States during the next 12 months at 42.7 per cent. I have this nagging suspicion that, if anything, that's on the low side.
So, buy bonds and wear diamonds. Be long or be wrong. As my old trading mentor, the late Prince of Darkness, was wont to say, "We'll be farting through silk."
Sr. Market Analyst,
36 Green Meadow Crescent,
Richmond Hill, Ontario,