July 23, 2011

WeeklyBasis 7/23: Rates & Debt Ceiling (part 2)

July 23, 2011

WeeklyBasis 7/23: Rates & Debt Ceiling (part 2)

Rates rose .125% last week, on target with last Sunday’s WeeklyBasis prediction that “rates should be even to up slightly.” As of Friday evening, there’s no budget deal in Washington so politicians will continue work on a budget compromise, which if it comes, will enable the debt ceiling to be raised.

August 2 is when the U.S. will reach its borrowing limit, so the target resolution date is next week. Short-term reactions have been higher rates for a budget deal and lower rates for no deal. Below is an explanation on why, and an outlook for the coming market week.

Preview of July 25-29 Week
The economic calendar begins Tuesday with May’s S&P Case Shiller home price report, the most market-credible of all monthly home price reports.

Last month, Case Shiller for April showed home prices were up 0.7, the first gain in eight months, but prices were down 4% since April 2010 and still at 2003 levels. The May data are likely to show a similar trend.

Also Tuesday, we have June new home sales which are expected at 320k which is similar to the 319k from May. Again, no big improvement expected, so it’s rate neutral.

Thursday brings June pending home sales, which is a report of homes for sale that entered into contract. It’s a gauge of buyer momentum in the market. While the May pending home sales were up 8.2%, April was down -11.3%. This report is also rate neutral.

Friday is the biggest day of regularly scheduled data with the first of three 2Q2011 GDP readings. Consensus estimates call for 1.6% growth vs. 1.9% final reading for 1Q2011. Expectations are low enough to where we could have an upside surprise, and even a slight upside surprise could cause rates to rise as investors sell bonds (pushing rates up) to buy stocks.

Rate Reaction To Debt Ceiling Saga
It’s all going to come down to the budget and debt ceiling debate. As discussed last week, there are two rate scenarios on the budget/debt ceiling negotiations:

(1) One theory says rates will spike if no debt ceiling deal is reached because ratings agencies will downgrade U.S. debt. But U.S. Treasury and mortgage debt is still the preferred safe haven trade in a questionable global debt picture. So ironically, Treasuries and mortgages could rally short-term in a debt ceiling impasse, pushing rates down.

(2) Stocks will rise more if a debt ceiling deal is reached because it removes a key short term uncertainty factor, and rates would rise as Treasuries and mortgages sold on stock strength. It’s been a strong earnings season, and also stocks reacted positively last week to progress on Europe’s debt problems: Dow up 1.6% to 12,681, S&P 500 up 2.2% to 1345, and Nasdaq up 2.5% to 2858.

Being politically optimistic, the most probable scenario is number two. Combine this with rate-neutral housing data next week and possible (albeit minimal) upside surprise on GDP next week, and my outlook holds for a second week: rates even to up slightly.

But politics can change quickly as we saw Friday, so here’s how to manage rate volatility.