Bond Market Week Ahead: Why Is The 10-Year Note At 2.5% And Where Is It Headed?

The Week in Review

A solid bid to the Treasury complex pushed yields through the multi-month trading range and tested secular support at 2.47 percent. The 10 year closed at 2.518, down 0.12 percent on the week. The five-year note closed at 1.545 percent, which is just .02 percent above major support of its 200-day moving average of 1.525 percent. The yield curve flattened, with the 5y-30y spread moving into 1.795.

Last week's economic data was mixed. Retail sales, industrial output, capacity utilization and preliminary Michigan Sentiment all missed to the weak side. Housing starts, building permits, jobless claims and New York and Philadelphia manufacturing all topped expectations.

Related: ETF Outlook For The Week Of May 19, 2014 (QQQ, EPI, XHB, XLF)

Eurozone bond markets were mixed. The 10-year bond had its largest weekly drop since September, falling 0.13 percent to 1.33 percent. Peripherals, particularly Italy and Spain, had their first losing week of the month with a large 0.17 percent backup in yields on Friday.

Ukraine remained a wild card all week as tensions escalated with clashes between government forces and separatist militants.

The Week Ahead: Data and Federal Reserve speakers

It will be a very light week for news and data. There is no data on Monday or Tuesday. The two important releases, in a light pre-holiday week, are the Initial Jobless Claims Report on Thursday and New Home Sales on Friday. The Fed will dominate the rest of the landscape, with six FOMC members speaking.

The most important day for Fed speak will be Wednesday with Fed Chair Janet Yellen and New York's William C. Dudley speaking, as well as the release of the latest FOMC minutes. In a thin, consolidating Treasury market, there will be an excess of volatility drawn from their headline risk.

This Week's Theme

What should we make of the rally in bonds in the short run and the intermediate term?

Next week, expect lon-dated Treasuries to consolidate recent gains around Friday's close of 2.52 percent in the 10-year note. The short-term oversold condition in both U.S. Treasury's and Eurozone sovereign debt, and the strong back up in Peripherals on Friday, should bring about a bounce in yields. The back up in the 10-year note will be closely correlated with moves in the S&P and Bunds, but will not retest the breakout level of 2.59 percent.

On the downside, it is too early to breakthrough major support at 2.47 percent, and even a retest is unlikely next week. Look for a thin market, and modest range, but enough excess volatility to create good trading opportunities.

In the intermediate term, once this consolidation is complete the bond market will continue its march towards lower yields. The "taper" sell-off in 2014 that many predicted simply has not materialized. The reasons now have been well documented.
• The Fed is still on a long-term low rate policy.
• There is short covering by the dealer and hedge fund community.
• Yields are attractive compared to Eurozone bonds.
• There is safe-haven buying on the back of geo-politics, China hard landing and weakness in emerging markets.
• There is pension plan buying against a backdrop of less Treasury issuance.
• Assets are being allocated out of equities.

The fact is that Central Banks around the world know that the global rate of growth is low, and inflationary pressures are not their primary focus.

Inflation rate in the U.S. is approximately 1.5 percent, year-over-year, and thus a 2.5 percent 10-year note represents just a one percent inflation premium (Yield less inflation rate=inflation premium). Compare the inflation premium in Bunds and JGB's of only 0.5 percent and you can see the premium is about one percent higher for Treasuries compared to other sovereign credits.

Interest rates on benchmark 10-year government debt and inflation rates are both very low and a worldwide event. U.S. 10-year rates are higher than similar credits because of a higher imbedded inflation premium demanded by the market. The Fed has been "printing money" for the better part of the last five years and bond buyers are requiring insurance for inflationary expectations. QE is already priced into the market, even at these levels.

So the real takeaway from this year's bond market rally is that the market is expecting slow growth, low inflation and real incomes under pressure going forward.

Posted-In: Bonds Economics Federal Reserve Markets Best of Benzinga

© 2014 Benzinga.com. Benzinga does not provide investment advice. All rights reserved.

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Dow Jones Industrials: What to Expect This Week

The Dow Jones Industrials (DJINDICES: ^DJI  )  gave up a modest amount of ground last week. But in the coming week, Dow investors have a lot to look forward to. Home Depot  (NYSE: HD  ) will look to close out the first-quarter earnings season for the Dow Jones Industrials, while the Federal Reserve will be in the news with its latest release of FOMC meeting minutes, and that could move shares of financial giants Goldman Sachs  (NYSE: GS  ) and JPMorgan Chase  (NYSE: JPM  ) . 

Home Depot has given investors one of the most impressive growth rates in the Dow Jones Industrials over the past several years, as the home-improvement retailer has managed to find ways to boost its business even during periods in recent years when the housing market wasn't as healthy as it has been lately. Now that housing has recovered, Home Depot has the opportunity to accelerate its growth by making use of its dual approach of courting both housing contractors and do-it-yourself homeowners. Competition has started to get stronger in the industry as Home Depot's main rival has stepped up its game and produce some impressive results of its own. This week, look to see if Home Depot can sustain its track record of profit growth and give positive signs for its near-term future.

Meanwhile, the Federal Reserve will release its latest Federal Open Market Committee minutes this week. As expected, the Fed chose at the end of April to keep interest rates at current low levels but to further reduce its bond-buying activity under quantitative easing. The reduction keeps the Fed on pace to eliminate bond buying completely by the end of this year.

For JPMorgan Chase and Goldman Sachs, what's most surprising about the end of quantitative easing is that it hasn't yet produced a huge spike upward in interest rates. After all, just the threat of reductions in bond buying a year ago made rates almost double. But worries about the stock market's health have made investors reconsider their risk tolerance, and that in turn has led to moves out of stock indexes like the Dow Jones Industrials and into perceived lower-risk assets like Treasury bonds. That trend has been good news for Dow banks JPMorgan and Goldman Sachs for a couple of reasons. JPMorgan has a mortgage-banking business that could see a reawakening of refinancing activity if rates stay at or fall below their current 2.5% level. Goldman could benefit from corporate refinancing at current lower rates, with at least one final wave of bond issuance before the falling demand for bonds from the Fed's exit stops the downward pressure on rates.

This week, the Dow Jones Industrials could continue to see volatility as investors assess the potential for a major correction. Keep your eye on JPMorgan, Goldman Sachs, and Home Depot in particular to see how they respond to the Federal Reserve's release and the end of earnings season.

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