Wednesday, July 8, 2009

Rates Strategy Update: Digging below the surface

Over the past month, UST and Bund yields have fallen significantly. I maintain my strategic long duration outlook amid expectations for only a muted and temporary recovery as well as the absence of any meaningful inflation pressures. However, there are several noteworthy developments which lead me to conclude that German Bunds appear a bit expensive from an RV perspective and are likely to consolidate before taking another leg higher:

The drop in 10y UST and Bund yields since June 10 was of similar magnitude (51bp vs. 42bp). However, in the US this drop stems almost exclusively from falling break-even inflation rates whereas in the Eurozone it is more down to an outperformance of Bunds vs. Swaps. First the US: 10y TII break-evens dropped by 47bp since June 10 and 10y reals by 3bp (real yields have even risen a bit over the past week). The drop in break-evens is confirmed by 10y inflation-linked swaps which are also down by 41bp. Furthermore, 10y nominal swap rates fell by 72bp during the last month and the swapspread tightened by 21bp as real yields incorporated into swaps dropped by 33bp. Now the Eurozone: 10y Bund break-evens dropped by 25bp and 10y real yields by 17bp over the past month. However, 10y inflation-linked swaps have risen by 5bp! In turn, the easing in inflation expectations which the development of Bundei suggests is not confirmed by inflation-linked swaps. Furthermore, 10y nominal swap rates could only fall by 27bp as the Bund-swapspreads widened by 15bp! Therefore, in the Eurozone the drop in Bund yields was much more due to an outperformance of nominal Bunds vs swaps and inflation-linked Bunds than due to a fall in inflation-expectations.

Why this diverging behaviour? I guess that the outperformance of US Swaps is largely down to an unwinding of convexity hedging performed in swaps during the previous sell-off (remember: convexity hedging amplifies swings in yields as it leads to swap receiving during a bull-market and swaps paying during a bear-market). The chart below compares the development of 10y US and 10y Eurozone swap spreads. During the risk-recovery period since mid March, swapspreads tightend in the US and the Eurozone (amid rising supply worries, recovering risk appetite etc.). However, during the last phase of the bond sell-off starting mid-May, USD swaps underperformed driving US swapspreads significantly wider, probably down to convexity hedging. This has now been recovered. On the other side, in the Eurozone, the fall in yields amid easing government bond supply worries and rising risk appetite has led to wider swap spreads.

Source: Bloomberg

Where to go from here? I remain bearish on inflation-linked products on a medium-term basis. However, amid the significant difference between break-evens priced into inflation-linked bonds and the level of inflation swaps, it is much more the latter which should drop and here especially EUR inflation-linked swaps appear too high. I do not see how inflation pressure can be rising if risk aversion is rising, commodities are falling and the green shoots are turning yellow which puts a dampener on recovery hopes.

UST and Bund yields can drop further over the medium term. Positioning in the US bond futures according to the CFTC remains heavily tilted in favour of shorts. However, I think that especially German Bunds should see a consolidation over the next days/2-3 weeks as they start to look technically overbought (see chart) while the reasons for the drop (rising swap spreads) has rendered them rather expensive vs. swaps and vs. USTs. Therefore, 10y UST-Bund spread tighteners (buying UST vs. Bunds) as well as temporarily shifting long duration positions out of Bunds into EUR swaps is advisable. For investors wanting to move on the long side/adding to longs, I think that the next 2 weeks should offer the first real possibility to do so since the bull move started last month.

So, strategically I remain bullish on UST and Bunds but from a tactical perspective I move to a neutral stance and look for an underperformance of Bunds.


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