Monday, June 29, 2009

Easing inflation fears...

This month's rallye in government bonds has been mainly driven by easing inflation fears. The chart below shows the development of 10y US break-even inflation rates and 10y real yields since the start of the year. Just as the rise in UST yields has mainly been driven by rising break-evens, the latest fall stems to a large degree from the reverse. Break-evens fell by some 40bp from their recent highs whereas 10y reals are only some 10bp lower.
In the Eurozone both, the real yield on the Bundei16 and on the OATei20 have dropped by some 20bp with break-evens down approx. 30bp (real yields and break-evens did not peak at the same time). So, while Eurozone real yields dropped more than in the US, the drop in nominal yields has still come mainly from easing inflation expectations.
First, real yields usually drop due to easing growth expectations/expectations for low short-end central bank real yields (aka accommodative monetary policy) or easing supply worries/rising risk aversion. As the drop in real yields has not been pronounced, changes in any of these factors have probably as well not been very pronounced. In turn, easing supply worries following last week's relatively well-received auctions (where, however, a change in the methodology to calculate indirect bids has played a role as well) should not be seen as the major cause for lower UST yields. Second, break-even inflation rates usually drop due to lower inflation expectations, a lower inflation risk premia (i.e. lower volatility of expected inflation) or as was the case following the Lehman bankruptcy due to a negative liquidity premia associated with inflation linked bonds relative to their nominal counterparts. The latter point is currently not significant given that break-even rates incorporated into inflation linked swaps are falling as well and the most likely cause is a drop in inflation expectations. News on the inflation front has been positive, i.e. no short-term inflation pressures are apparent and also the run-up in commodity prices has taken a breather. This should be seen as positive for the economy (as high commodity prices act like a tax on consumers and corporates in a net-commodity importing country) and therefore dampens the rise in risk aversion.
As I mentioned frequently, I not only see almost no short-term inflation risks given the significant and ongoing rise in spare capacity amid falling demand, I also dont expect inflation to rise to worrying levels (i.e. above 5% or even double-digit rates as some observers fear) over the next few years.
Inflation expectations can fall a bit further in the weeks/months ahead amid a lack of any such pressures building in the short term. Furthermore, I expect that real yields will be able to fall as well, however, this might well take some more time before it becomes more pronounced. Lower real yields - besides being down to easing supply pressures - should go hand in hand with reduced growth expectations and this will probably materialise only slowly as the recovery will likely be more subdued/shorter than consensus is looking for.
In turn, I maintain the long duration call for government bonds and also think that higher-rated corporate bonds remain an attractive investment from a shorter as well as more medium term perspective.

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