Thursday, June 11, 2009

Have we seen the highs in UST and Bund yields?

In the post "Recovery or just getting less bad" dated May 27, I stated that "while government bonds should face more headwinds in the short term, I expect that over the next 1-2 weeks government boned yields should stop rising, slowly followed by yields trending towards the 3% again for 10y Bunds and UST during summer." In addition, this Monday June 8 I stated that "I maintain the view that the yield highs are close and we should top out in the days ahead" (see: Breakdown in EURUSD and Gold signs of things to come?). So as two weeks have past since the former and four days since the latter post, have we now seen the yield highs for Bunds and UST?
First there are fundamental reasons for lower yields from current levels: Yes, the economic situation is getting less bad compared to Q408/Q109 but any positive growth momentum will remain dependent on macro-economic stimulus for a prolonged period of time. The most likely scenario is that following a move back into positive territory during H209, growth will oscillate around 0% for several more quarters. Furthermore, despite all the talk about inflation being around the corner, I remain unconvinced. The deflationary impetus of the private sector deleveraging is far from having run its course (see for example the previous post: consumer deleveraging spiral still getting worse). I am not yet concerned about the balance sheet lengthening of for example the US Fed as velocity of money is falling. Furthermore, most of the expansionary monetary policy measures can be reverted relatively easily (I am more concerned about the size of the budget deficit as history shows that it is much more difficult to reduce the cyclically adjusted fiscal deficit).
So overall, I expect nominal GDP (which shows a good long-term relationship with nominal yields, see chart) to remain subdued for a prolonged period of time. In turn, longer-dated UST yields should remain relatively low as well. 10y UST yields of close to 4% do not fit with the outlook for nominal GDP growth of below 4% for the next several quarters.

From a more shorter term perspective and as mentioned earlier, positioning by speculative accounts in US bond futures is heavily tilted in favour of shorts. Additionally, consensus has shifted to a bear-market base scenario for government bond yields. Furthermore, technicals are now oversold. In combination, this suggests that a lot of the negative news for government bonds is now factored into positioning and price.
Finally, I think that we have touched a major correction level in 10y Bunds this week, the 50% Fibonacci retracement of the Jul08-Mar09 upward move. This Fibonacci level is on the adjusted future chart at 117.44. The bund future traded down to 117.47 on Monday and to 117.52 today.
Overall, therefore, I see a larger than 50% probability that we have seen the highs in 10y UST and Bund yields this week and that we are now in a topping process for yields/bottoming for prices with no new significant yield highs. My basecase of yields falling during summer remains intact.

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