Bond Market At Mid-year

As I have previously discussed, the US bond market is very
sensitive to the momentum of production plus sensitive materials
prices. The latest upturn in bond yields started around the
end of November, 2006 and it remains intact. Over this same
period, the six month annualized rate of change in cyclically
sensitive industry has risen from 3.0% to 10.2%. Since US
production has been sluggish, the damage to yields has come
largely from strong industrial commodities prices, reflecting
high capacity utilization rates and strong international
growth.

Although I was surprised by how weak May durables orders were
(as reported today), the lead indicators I follow closely are
still signaling a stronger second half for the economy. So I am
stuck with the view that bond yields may well trend irregularly
higher as the year progresses. Interestingly, there is usually
at least one period each year when industrial commodities prices
turn weak. That tends to occur around mid-year, perhaps because
smelters, mills and other smokestack production may elect to take
a little downtime in the warmer weather. At any rate, normal
seasonal weakness in sensitive prices could bring some improvement
in the bond market near term.

My super long term model, which regresses the Treasury bond yield
with inflation, suggests the bond should now be yielding between
5.75% and 6.25%. Trading around 5.20%, the long guy is well below
the indicated range. So, the premium for interest rate and inflation
risk has trended down in the new century. I attribute it to the
combination of strong financial liquidity coupled with moderate
inflation levels as well as the role of Treasuries in a variety of
swaps and other derivatives programs. I am not happy with this
explanation because Treasury yields do not correlate that well
with liquidity trends. I am also figuring that a combination of
eventual faster US production and ultimately higher sensitive
materials prices might bring the long bond yield closer to the
indicated 5.75 - 6.25% range.

The long Treasury yield is however high enough to trade now, which
I did recently. The investment case remains unappealing, especially
since there is decent grade short paper out there at 5.25 - 5.50%.

I note that the spread between high yield or junk bonds and Treasuries
is an exceptionally narrow 300 basis points. Since junk trades like
junk in more stressful economic times, no one is being adequately
compensated to own the stuff now. As the economic expansion
matures, the eventual migration to quality will begin....