Monday, June 22, 2009

Rates Strategy: How to position

I maintain the government-bond bullish outlook which I adopted some 10 days ago. Besides recommending a long duration stance, I want to give some more details on what I consider attractive positions.
A) Duration: as mentioned, I expect UST and Bund yields to fall during summer. I think that a medium-sized long position (+3/4 on a scale of 0=neutral to 6=maximum long) is reasonable. I expect help for the bond market from several angles (valuation is relatively favorable, so are technicals while expectations for the economy have become a bit too positive). However, I do not expect the economy to fall off a cliff again as happened after the Lehman collapse. In turn, risky assets - which I expect to drop in value - should as well not collapse. In turn, Bund and UST yields should fall, but not dramatically and not in a straight line. Rather, I think we will trade down towards the 3% area in both, 10y UST and 10y Bunds within a period of 2-3 months.
B) Curve: Usually yield curves are bull-steepening and bear-flattening. This is because longer-dated expectations for inflation and growth are more stable than shorter-dated expectations which in combination with central banks conducting monetary policy via changes in the short-term rate leads to short-term yields being more volatile than longer-dated ones. However, as short-term yields have become very low, central banks' ability to change short-term policy rates has become very limited and instead the need to conduct moentary policy via alternative measures (quant and credit easing) remains high. These alternative measures have more of an impact on longer-dated rates (via quant easing, need/commitment to keep rates low for a prolonged period of time) and on credit-related yields (credit easing). All these factors increase the volatility of longer-dated yields relative to short-dated ones and change the dynamic of the yield curve to bull-flattening and bear-steepening. This is more apparent in the US than the Eurozone (given that Fed funds are almost at 0% and given that the US is engaging in QE). In turn, the US yield curve is prone to bull-flattening, suggesting that long-dated UST are the preferable part of the curve during a rally. In the Eurozone, the yield curve has more scope to bull-steepen which I expect to happen in the 5-30y area. In turn, I expect yields to fall most in the 5y sector and I think steepeners are attractive in the above 5y segment. However, in order to get a long duration position on board and in terms of total return, the 10y and above segment. Though, beyond the 15y segment, to me the curve appears a bit too flat. But that might not change soon as pension funds might be forced to continue getting duration on board.
c) Currencies: I prefer the USD from an absolute return perspective as it should profit from rising risk aversion. Also for the bond markets I see most potential in USTs amid relatively high real yields (given the economic circumstances). Also for Bunds I see a good potential (albeit a bit less as USTs usually have a higher volatility than Bunds and therefore USTs outperform in a bull market). However, here the EUR is likely to weaken and therefore investments should be more on a currency-hedged basis. With respect to Gilts I am a bit more cautious. I have some doubts about the longer-term sustainability of the UK situation (it is a similar mess as the US but just not that important as a reserve currency). Furthermore, even though inflation has been dropping, its trend is not as favorable as in other countries. Therefore, I recommend a less pronounced long exposure in the case of UK Gilts than in the US and the Eurozone.
d) Spreads: Credit spreads are likely to widen and lag the performance in Bunds/USTs. However, I would assume that the likely widening in spreads will not be of such an indiscriminate nature (and clearly not as pronounced by far) as following the Lehman collapse which saw spreads of any credit product blow out sharply. I would rather assume that we see an increased discrimination between industry segments, depending on the overcapacity in a given industry/the outlook for demand etc. So my guess would be that for example utilities hold in better than lets say autos (whereas both widened sharply during autumn) or other durable consumer goods. So a more defensive positioning within credit is warranted with an overweight of higher-rated, less cyclical issuers at the expensive of lower-rated cyclical ones.

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