In the midst of last year’s severe economic downturn the best place to protect capital was in the U.S. Treasury markets.  In fact, long positions in the Treasuries did not just protect capital, but actually resulted in substantial gains.  Treasuries enjoyed their biggest advance in many years, while stock index futures were in a freefall. There was a myriad of reasons to be long Treasuries and short the Stock Index futures.

CREDIT CRISIS

Last year it was paramount to seek the safety of U.S. Treasury issues, while avoiding long positions in Stock Index futures during their extended bear market. At the height of the credit crisis there were some estimates that global write downs, due to losses in the credit markets, could be as high as $1.3 trillion. This was substantially more than the International Monetary Fund’s estimate of $945 billion. The usually optimistic Federal Reserve chimed in when the president of the Federal Reserve Bank of Minneapolis said that the credit problems in the U.S. markets might get worse. One money manager said banks are only “one third through” their credit related write downs. All of this was very Stock Index unfriendly and bullish for the Treasury futures market.

CONSUMERS

Consumers continued to have a difficult time getting credit lines and loans, while consumer spending deteriorated as the problems on Wall Street moved through the economy. In addition, there were concerns that last year’s holiday shopping season would not be robust. In one month late in 2008, consumer purchases fell 1.2%, which was the third consecutive monthly drop. In this period, declines in retail sales were the largest since August 2005. This deteriorating situation accentuated stock index weakness and Treasury market gains.


HOUSING MARKET

The trends in the housing industry last year argued for being long Treasury futures and short stock index futures, as well. There were worries that any U.S. bank bailout plan would not jump start lending as potential homebuyers continued to remain on strike. Pending home sales, which are based on signed purchase agreements, were at their lowest level since records began in 2001.  This statistic was especially bullish for the Treasury futures market and bearish for the stock index futures, since the pending home sales report is widely thought to be a leading indicator of the housing industry. This is true because pending home sales reflect signed contracts as opposed to existing family home sales, which are tabulated and reported one to two months later.  Housing statistics at the time suggested that the housing recession was the worst since the 1930’s and there was a growing feeling that there would be more problems related to the precarious housing industry.

AUTOMOBILE MANUFACTURING

Adding to the pressure on stock index futures and the gains in the Treasury futures was the deteriorating situation in the automobile manufacturing industry. At the time, auto makers continued to eat through cash reserves as sales fell. This situation was so severe that it was imperative that the industry receive a federally funded aid package in order to avoid a collapse. There were concerns that one of the major U.S. manufacturers could run out of cash reserves before the end of 2009.  The industry requested $50 billion in loans with approximately half going into operations and the other half to be applied toward health care expenses. There was talk that without a bailout package the end result could be a loss of over a million jobs.

CENTRAL BANK POLICIES

All of the major central banks eased credit conditions dramatically. On December 16th, 2008 the Federal Reserve drastically lowered their benchmark interest rate, the Fed Funds rate, by 75 to 100 basis points to a range of zero to 25 basis points.  Even this extreme form of accommodation proved to not be enough to quickly revive the U.S. economy. It became more evident that more stimulus, other than just zero short term interest rates is needed.  Of course, this was extremely bullish for Treasury futures and only temporarily supported the Stock Index futures.  

Late last year there were some analysts that were thinking that the Federal Reserve should start buying Treasury issues directly from the Treasury Department in order to keep long term interest rates low.



This, in turn, was expected to put downward pressure on mortgage rates and stabilize the beleaguered housing market. The Federal Open Market Committee did establish a policy of quantitative easing, which was the next level of accommodation when a zero interest rate policy (ZIRP) was not working or was not working fast enough. Quantitative easing (QE) is a process where a central bank buys debt directly from the government. This operation has the result of adding large amounts of liquidity into the banking system, which in theory, will very quickly reduce yields on government bonds and reduce interbank overnight interest rates. All of this was very bullish for the Treasury futures market.

There was additional upward pressure on the Treasury futures prices when the Bank of England dropped their benchmark interest rate to the lowest level since the Bank of England was founded in 1694. The European Central Bank lowered their benchmark interest rate as well, to a record low and the Bank of Japan cut their main interest rate to 10 basis points from 30 basis points. While the easier credit from the Federal Reserve and other major central banks was well intended, it appeared to be too little and too late to immediately help the economy and that more accommodation would be needed.  All of this accommodation was very bullish for the Treasury futures. Stock index futures continued to plumb new lows, while waiting for the economic stimulus to have an effect.

THIS YEAR’S BATTLE

This year’s battle is totally different from last year’s battle. This year the battle is the “battle of disbelief.”  Many traders and institutions do not believe that the recent substantial gains in stock index futures are warranted and that the worst of the recession is not behind us.  They continue to fight last year’s battle by seeking the “safety” of Treasury futures, while maintaining a bearish outlook on stock index futures. Although this strategy worked well last year, we believe that this is the wrong way to be positioned now.   Many market participants are operating on the mistaken belief that all or most of the fundamentals that drove financial markets last year will re-exert themselves again this year and next year. In addition, the bears on the economy have some new concerns. They are worried that higher short term interest rates and firming commodity prices are bearish for the economy. Firming commodity prices in the past were thought to be a bearish influence for an economy because of their inflationary implications.  

 

 

We take an opposite view. Under the present circumstances, rising prices for commodities can be viewed as a sign that manufacturing activity is about to increase. At this stage of the economic cycle, a higher interest rate structure is actually a bullish development, since it can be construed as an indication of anticipated greater loan demand in the near future. If we are correct in our thinking that the economy is recovering, we should not be afraid of rising interest rates. Our analysis continues to show that the worst of the global economic downturn is behind us and that we can expect the majority of the economic reports for the balance of this year and though 2010 to be stronger than the analysts’ expectations. As the global economy continues to recover and Stock Index futures continue to advance, the credit markets, especially the longer dated maturities will suffer. Our analysis, which places considerable weight on the shape of the yield curve, which is upward sloping and is considered to be normal, continues to suggest that there will be a slow recovery that will gradually accelerate into next year.


 

We continue to believe that the worst area to be long now is in the longer term Treasury markets. In fact, as the global economy continues to recover, it is likely that Treasury futures prices will move lower for the balance of 2009 and will continue to fall well into next year and that there will be additional gains for stock index futures this year and well into 2010.         

If you have any questions or comments about this article, please contact Alan at 1.800.243.2649 or send him an email to alan.bush@archerfinancials.com.

Futures and options trading involve significant risk of loss and may not be suitable for everyone. Therefore, carefully consider whether such trading is suitable for you in light of your financial condition. The views and opinions expressed in this letter are those of the author and do not reflect the views of ADM Investor Services, Inc. or its staff.  The information provided is designed to assist in your analysis and evaluation of the futures and options markets.  However, any decisions you may make to buy, sell or hold a futures or options position on such research are entirely your own and not in any way deemed to be endorsed by or attributed to ADMIS. Copyright © ADM Investor Services, Inc.