Thursday, June 4, 2009

Outlook for Government Bond Yields

I wrote last week (Recovery or just getting less bad?) that Bund and UST yields should stop rising within a period of approx. 1-2 weeks and then slowly start trending lower again towards the 3% area during the upcoming months. I still think this is very likely even though the recovery hopes will not go away soon (but are likely to receive further nourishment in the near term).
The reasons for the end of the current bond-bear market are several:
a) As shown previously, a lot of the former liquidity premia has been priced out of UST (and Bunds) and in turn I do not regard govies as expensive anymore.
b) According to the CFTC, risk-weighted net positions at the long end of the UST curve via 10y and 30y futures have now reached an all-time record (see chart), i.e they are even more pronounced than in early 2004 just ahead of the last hiking cycle (first hike was in June 2004).c) inflation rates priced into inflation-linked swaps (again, I think swaps give a better indication of inflation expectations than break-evens priced into TIIs due to various premia) are back at levels last seen at the beginning of 2007, i.e. just ahead of the housing market crash and the deleveraging cycle. Even with the latest rise in oil prices, it is hard to see how inflation linked products can generate a positive carry over the next few months and quarters.
d) the talk about a potential downgrade of the US seems very premature. Additonally, while the bond supply will remain huge given the fiscal deficit, demand is there as well as the share taken by indirect bidders at the last few auctions has shown.
e) the technical situation appears oversold (but no buy-signal given so far).

So overall, I think that the pessimism with regards to the outlook for government bond yields (especially USTs and Bunds) is overdone and I would look for a friendlier picture to emerge over the next few months (probably led by a drop in break-evens in the first stage).

1 comment:

  1. Hi Daniel... Really thanks for your great view... JJ