Monday, August 31, 2009

Deflationary threat: good or bad?

I have frequently stated that most of the so-called developed markets will see only very limited inflation pressures for the next several years (with a significant risk of an inflationary outcome in the UK, however). This per se does not need to be bad for an economy. Rather to the contrary, I think that a low-inflation outcome can help countries such as Germany, France & Switzerland which do not have an overindebted household sector to shift their focus more towards domestic consumption (and away from exports) amid raising purchasing power. On the other side, in countries with over-indebted consumers such as the US, a low inflation outcome can be much more damaging for the economy as it increases the risk of a debt-deflation spiral.

Macroblog has some interesting charts on the US inflation development:

To quote macroblog: "A key observation to take away from this picture isn't the recent acceleration in core goods prices. The highly volatile behavior of goods prices tends to make them an unreliable guide to underlying inflation trends. Rather, it is noteworthy to consider the significant downward trek of core services price growth. Indeed, the 12-month trend in core services prices was a shade under 1.6 percent in July—its lowest reading in the post-WWII era and roughly 1¾ percentage points lower than this time last year."
I would add that the deflation scare earlier this decade following the bust of the dot-com bubble stemmed almost exclusively from the drop in goods prices. However, relatively more goods are tradable internationally than services and therefore international competition should play a larger role in influencing goods prices. Services prices, on the other hand, should be relatively more influenced by domestic factors. The drop in goods prices itself is likely to have stemmed from increasing globalisation as well as technological progress. This, however, is rather a positive deflationary threat down to productivity gains which helped render households richer in real terms (as they have to spend less for their goods consumption).

This time, however, the deflationary threat in core CPI stems largely from the services component. To quote macroblog again: "Some of the downward pressure on core services prices is a direct reflection of the housing crisis; a little more than half the core services price components are computed from housing rents. But that's not the whole story as a rather sharp disinflation was evident in core services excluding rents."

Services are usually more labour intensive to produce than goods (and again, the share of imports in goods conumption is higher than in services consumption). As a result, the strongly disinflationary trend in core services CPI adds to the need of cost-cutting measures which in the services sector means headcount reductions, even more so than in the goods producing sector.

Furthermore, if we look at the development of personal income (see chart below), then the picture becomes even more dramatic. Personal income is down by around 2.4% over the past 12 months. The last time personal income dropped by this amount was for a brief period just after WWII. However, personal income never dropped during the past recessions.

US personal income yoy vs. recession

Source: Bloomberg

Amid the strong disinflation in core services CPI as well as the fall in personal income coupled with the highly indebted households, I continue to see the risk of a bad deflation outcome in the US, i.e. one where the gain in purchasing power amid lower prices does not outweigh the additional burden brought about by higher debts in real terms.

The situation is different, though, in countries where households are not overly indebted (and house prices are not falling) such as Germany, France or Switzerland. Here, the positive effect on purchasing power by the currently low to negative readings in CPI promise to be far more substantial. For one, households balance sheets are not overly leveraged (i.e. households indebtedness is relatively low) while house prices have not bubbled to the same extent as elsewhere and are therefore not dropping significantly at present. Furthermore, so far unemployment has risen only moderately, leaving personal income largely intact. In turn, the current low to negative CPI further supports the rebalancing of these economies away from their large export-dependency (especially in Germany and Switzerland) towards more domestic consumption.

Thursday, August 27, 2009

Lessons from the Swiss investment case

I have already previously written about my relatively positive medium term economic outlook for Switzerland (see Switzerland 2 - 0 UK dated July 13). I suggested that the combination of higher tax rates in other countries coupled with a weakening banking secrecy for non-residents renders moving to Switzerland for wealthy and/or high-earning indviduals as well as corporates attractive. This in turn helps to fuel domestic consumption, raise real estate prices (especially in the high-end areas) and supports the tax intake of the Swiss government amid a larger tax base.
This Evening Standard article (Darling's 50% tax sends tycoons to Switzerland) supports my argumentation. It states that: "The advent of the 50% tax rate appears to be the final straw for many hedge funds and other money firms who are being actively lobbied by the Swiss authorities to decamp to Zug, Zurich or Geneva. They are being promised that in Switzerland they can hide from increasing European Union regulation or the intervention of watchdog agencies like Britain's Financial Services Authority."
However, besides this investment case, Switzerland also provides an interesting basket case in terms of rebalancing an export-dependent economy as well as insights into a likely outlook for government bond markets elsewhere.
Firstly, even more so than Japan and Germany, Switzerland is overly dependent on export (accounting for roughly 50% of GDP with the current account surplus standing at 10% of GDP in 2008). Otherwise it does not have significant internal imbalances (no overvalued housing market, no overindebted/undersaving consumers, no weak fiscal position). Therefore, fiscal easing in combination with ultra-low interest rates promises to be able to support domestic consumption to a significant extent. Finally, given that neither households nor corporates and also not the state are overly indebted, a debt-deleveraging spiral is not on the cards. Rather to the contrary, low and even slightly negative inflation rates help to maintain purchasing power and keep bond yields at ultra-low levels.
Secondly, as the chart below shows 10y Swiss government bond yields are at an interesting crossroad. Even though the global economy has stabilised and risky assets could recover significantly, 10y Swiss govie yields are back to the lows prevailing early this year. Technically, they are in a so-called triangle, with a strong support at current levels given that it has been tested several times this year. On the other side, there is a clear downward trend prevaling since June. Which one will win out is not clear from a technical perspective. However, fundamentally, the prospects for ongoing low nominal GDP growth (amid non-existent inflation and subdued export growth) as well as the fact that the fiscal situation of Switzerland remains healthy (relatively low indebtedness and a roughly balanced budget) would suggest that longer-dated Swiss government bond yields can stay low for longer and even fall further amid a flatter yield curve.
Swiss government bond yields back to their lows
Source: Bloomberg

The low yields clearly help to rebalance the economy away from exports and more towards domestic consumption and investment with low inflation not standing in its way. This could as well be the case for Germany where there is no significant debt overhang which would be accompanied by the risk of a debt-deflation spiral. Again, growth is likely to be muted over the medium term amid subdued growth in exports. However, low inflation would help to maintain purchasing power while low yields would support domestic investment and the housing market.
Within Europe, I remain more optimistic for Switzerland and Germany than the overly indebted countries such as the UK, Spain or Ireland from an asset allocation perspective. Furthermore, the Swiss example supports the notion that government bond yields can fall further, especially in export-dependent countries with limited inflation pressures such as Germany.

Wednesday, August 26, 2009

Commodities and related markets to fall first?

Equities continuing to roar ahead while government bonds are trading supported has a goldilocks taste to it. As mentioned on Monday (see Rates Strategy Update: Sticking to longs), I think that equities rally on the back of the improving growth outlook whereas bonds trade supported amid a lack of inflation pressures. On the other side, the development of commodities on average remains relatively muted with several important commodities seemingly going nowhere over the past weeks (for example oil and gold). While I still continue to look for the equities rally to falter, it could well be that commodities and related (emerging) equity markets will lead the way.

Earlier this year it was the emerging markets world (most notably China) which led the risky asset rally and in conjunction with ultra-low central bank policy rates and the quantitative/credit easing measures were fuelling the fear of rapidly rising inflation rates, especially via a liquidity-induced commodities rally. If anything, long commodities seemed to become a consensus trade. Furthermore within equities money was flowing towards the emerging markets world. However, as the chart below shows, commodities have significantly lagged the upswing in equities. I have set the S&P500, the DJ EStoxx and the CRB-Index at 100 for March 6 (the day of the equity low). Since then, the S&P and the EStoxx have traded almost exactly in line with the same performance. However, the CRB Index has trailed the substantial equity performance by a significant margin. Furthermore, especially over the past month, there is a discrepancy with commodities trading sideways to lower and equities rallying further.

Commodities lag equities
Source: Bloomberg

Bringing government bonds into the picture as the chart below does via 10y Bund yields suggests that bond yields are currently moving more in line with commodities than with equities and as a result show the same discrepancy in terms of performance.

Bonds trade in line with commodities and less with equities
Source: Bloomberg

The lacklustre performance of commodities supports my notion that bonds have been moving higher/yields lower on the back of easing inflation fears. But why is it that commodities fail to rally in line with equities? Furthermore, is the performance of commodities a sign of things to come for equities (i.e. a lack of end demand as a precursor for renewed growth weakness) or another positive for equities (as it eases inflation worries and helps to keep rates low for longer)?
For one, I think a key reason why commodities seem to be going nowhere these days can be found in China. China seems to have gone on a commodities re-stocking spree (see for example The China Syndrome by MacroMan) and has injected a massive dose of credit into its economy earlier this year. However, both seem to have come to an end as the announcement of a stricter lending environment by Chinese officials suggests. This was also mirrored by the Shanghai equity index which is down some 15% since the start of this month. The end of the commodities restocking cycle would also explain the easing in the Baltic Dry Index which already topped in early June but is down another 25% this month:
Source: Bloomberg
Clearly, easing commodity prices are a positive for net commodity-consuming economies such as the US or the Eurozone and constitute a positive terms of trade shock via lower imported inflation. Furthermore, as it eases still persisting inflation worries it allows central banks to keep ultra-low policy rates for longer. Thereby, this would come a long way in explaining the recent co-movement of government bond prices and equities (both up).
Furthermore, I remain of the opinion that there is more downside for commodities in general amid relatively less demand and because any re-stocking can not go on forever (first, it is costly to hold physical commodities and second, there are no infinite storage capacities). Given that a lot of speculative money seems to have flown into commodites and related equity markets, it might well be that performance disappointment sets in which would lead to downward prices on such assets. In turn, I maintain my negative view for the commodities complex and the bullish outlook for government bonds.
From the data I have available, I cannot judge yet whether the developments in commodities is a sign of a broader weakness in end demand or just due to the end of the re-stocking cycle and less speculative flows. If purely the latter, then the positive impact on developed market equities might be sustained, however, if more from the former, then we should see the US and Europe be dragged lower as well via renewed weakness in exports. So far, my view remains that the equity rally will falter soon amid renewed growth disappointment.

Monday, August 24, 2009

Rates Strategy Update: sticking to longs

Clearly over the past days risky asset markets have been stronger than I anticipated. However, given the new highs in equities, the performance of government bonds has been remarkable. While US Treasuries traded close to their early July highs, the Bund future even managed to print another high late last week and the 10y Bund yield traded down to 3.22%. This is the lowest since the start of May and up only some 40bp since mid-January.
But why have government bond yields not moved higher recently?
The reason I think is because (nominal) government bond yields over the longer run tend to move in line with nominal GDP growth rates. The charts below show the case for Japan and the US.
Japan nominal GDP (incl. 12period moving-average) vs. 10y yields
Source: Bloomberg
US nominal GDP vs. 10y constant-maturity Treasury rate
Source: Bloomberg, St. Louis Federal Reserve

While the strong performance of equities has to be seen in the light of ongoing and spreading positive surprises for the outlook of real growth, government bonds have been largely underpinned by lower-than-anticipated inflation numbers. While the return to positive real growth rates is occuring faster than previously anticipated, inflation is lower than expected and nominal growth tends to still be in line with previous expectations. Therefore, government bonds have so far not suffered that much from the equity bounce of the past week. However, if positive real growth surprises persist, they will sooner or later - and despite the lack of current inflation pressures - push expected nominal growth rates higher which would hurt government bonds.
So far it does not look like we are at that point already. Furthermore, I still believe that the near-term growth outlook has become too positive as parts of the improvement of the past months is down to seasonal adjustments which should be reversed following the summer recess, i.e. around now. Therefore, I stick to a positive government bond outlook with longs in the US and the Eurozone.

Friday, August 21, 2009

Germany and France moving higher?

Following positive growth in Q2 in Germany and France, today's manufacturing and services PMI contained another positive surprise for both with the French manufacturing moving to 50.2 and the German services PMI surging to 54.1, i.e. above the 50-level. Both countries exhibit only limited internal imbalances (no overvalued housing markets, no over-indebted consumer and a relatively moderate level of consumption relative to GDP in the mid-50% area). In Germany, the problem is more its huge export-dependency as well as the significant losses in the banking sector (which I think stems largely from the fragmented domestic banking market where banks instead of merging to increase market share and profitability bought significantly into securitized assets to generate income). The French dependency on exports is significantly less but exports still account for roughly a quarter of GDP. However, the corporate sector is showing a significant financial deficit. Therefore, for these two countries (together with some others such as for example China or Switzerland) the role for fiscal policy has been more promising in stimulating internal demand to cushion the downturn and help the economy to recover amid increasing domestic consumption. While several measures are likely to just have brought future consumption forward (such as cash-for-clunkers), in general, it seems that these measures have proved rather successful.
Furthermore, given that the rise in unemployment has been relatively moderate in both countries so far, the risk of wage-deflation spiral is also not pronounced and the easing inflation rates will rather help to improve purchasing power. This seems to be confirmed by this article stating the purchasing power of French families is maintained despite the crisis (it is in French).
On the other side, in countries where a debt-fuelled housing and consumption boom has left the consumer overindebted and undersaving and the economy overly dependent on consumption (such as the US, the UK but also Ireland and Spain), the longer-term outlook for internal demand remains much more subdued and the ability of governments to stimulate consumption more limited.
Finally, Germany has - amongst other things - been burdoned earlier this decade by too high real interest rates within the Eurozone (weaker economy than the rest of the Eurozone--> lower inflation -->higher real interest rates). This was also a reason why no housing boom materialised and why households rather saved than spent. However, with growth seemingly recovering whereas other Eurozone countries remain mired in recession, it could well be that instead of too high real interest rates as over the past decade, they could become too low for the German economy. This would be an additional factor in helping the economy to shift its focus more towards domestic consumption and investment and away from exports.

Overall, the outlook for Germany and France remains relatively favorable and the impact from easy macro-economic policy promises to be more effective than elsewhere.

Wednesday, August 19, 2009

Worried about deflation

News from the inflation front (except in the UK) remain strongly disinflationary and suggest that the deflation risk is still growing.
Yesterday's US PPI release was a case in point. The yoy rate dropped to -6.8% from -4.6% in June. This is a new post-WWII record low (see chart)! Furthermore, never since WWII has the yoy rate dropped as fast and as far (down from +9.8% as recentely as August 2008) as over the past 11 months.
Source: Bloomberg

The high level of underutilised capacity (aka the output gap) as is evident by the record low capacity utilisation rate and high levels of unemployment suggest that imminent pricing power by corporates and households remains weak and inflationary fears remain overdone. Not only are headline inflation rates negative in the US and the Eurozone but more importantly core inflation rates have started to come down significantly. US core inflation dropped from 2.5% in September 2008 to 1.5% in July this year. During the same period Eurozone core inflation fell from 1.9% to 1.3%. The levels of the last recession (1.1% in the US and 1.2% in the Eurozone) are approaching fast and are very likely to be undershot significantly and for a prolonged period of time.
Source: Bloomberg

I have also written on several occasions about the low medium-term inflationary threat posed by the lenghtening of the US Fed's balance sheet (see for example Not again: inflation - or the lack of it). Basically, broad based credit aggregates are falling by more than narrow-based monetary aggregates are rising. However, once broad-based credit aggregates are rising again (which can take a long time as it needs both, banks which are willing to lend and households/corporates which are willing to borrow), we should also expect narrow-based monetary aggregates to fall again. The ultimate inflationary pressure will be very limited and take a long time before it becomes evident. For the time being, we still have too little money chasing too many goods resulting in disinflation.
In this respect, I still think that current break-even inflation rates priced into US Tips and Eurozone linkers appear too high. In fact, I expect them to trade slightly below the 1.5% area in 10y within the next few months and therefore recommend to underweight linkers vs. nominal govies in the US and the Eurozone (not so in the UK where the inflationary threat seems much larger, see Revisiting the UK - not much good news).
Source: Bloomberg

One additional point: Bloomberg columnist Matthew Lynn argues in Deflation Theory is Lemon we have all been sold that deflation is no threat at all as historically falling prices went frequently hand-in-hand with healthy economic growth. I agree that there exists a so-called 'good' deflation (falling prices caused by technological progress). In fact the deflation scare early this decade can be attributed largely to the 'good' variety on the back of technological progress and globalisation. However, there clearly exists also a 'bad' variety of deflation, the one caused by a debt-deflation spiral, something Mr Lynn completely ignores. In such a debt-deflation spiral everyone wants to reduce indebtdedness which leads to a recession, rising unemployment and falling prices. As prices fall, real indebtdedness increases further, a vicious circle. While technological progress has not really been abating, also helping to limit inflation fears, the current deflationary threat resembles a debt-deflation spiral (at least in the US).
The chart below shows the development of a proxy for nominal weekly earnings with recessions shaded in grey. I calculated it using the index of aggregate weekly hours multiplied by the average weekly nominal hourly earnings (for further details please refer to: Consumer deleveraging spiral still getting worse). Nominal earnings for private sector employees are contracting at an unprecedented post-WWII speed. Over the past twelve months they have been dropping by 4.3%! It is very difficult for households to reduce debt on average if their incomes are deflating and therefore their debt is increasing in real terms.
Source: BLS, Research Ahead

Overall, I remain more worried about the disinflationary process than the inflationary threat and expect US and Eurozone break-even inflation rates to tighten again in the months ahead.

Tuesday, August 18, 2009

Revisiting the UK: not much good news

I already previously highlighted my worries with respect to the medium-term outlook for the UK (The UK: down and out dated July 7). While in the meantime the recovery has continued, my doubts about the UK outlook have not become less pronounced, rather to the contrary. I remain seriously worried about the more longer-term outlook and consider the risks for an inflationary outcome as being the most pronounced by far of any of the larger non-EM economies (I continue to expect US and EUR nominal growth to be very low for a multi-year period amid low real growth and low inflation).

Just to repeat: I think the structural problems the UK economy is facing are even more substantial than elsewhere. For one, the structural imbalances (overvalued housing market, over-indebted under-saving consumer, high current account deficit to name a few) are at least as pronounced as in the US. However, the banking sector liabilities are significantly larger and the share of the financial sector is larger than in the US.
For me, the key reason for the positive UK data surprises of the past months are down to the larger macro-economic stimulus than for example in Europe. First, the BoE was faster in cutting rates than the ECB and also engaged in a more aggressive asset purchasing program sooner. Additionally, the fiscal stimulus in the UK is significant. Finally, the drop in GBP on a trade-weighted-basis has provided an additional boost.

However, there is a real problem brewing and today's CPI release highlighted this again.
Yes, inflation in the UK has come down as well during the past quarters, however, this fall was much less pronounced than in the US and the Eurozone (yoy numbers):
Source: Bloomberg

Moreover, the fall in UK inflation was also much less than expected. The chart below adds the difference between actual inflation (mom value) minus the forecasted value (Bloomberg consensus). While during 2007, US inflation tended to overshoot vs. expectations, since mid 2008 this has been the reverse. In the Eurozone (I have used German inflation as it is been released relatively early), inflation tended to be more or less in line with expectations. In the UK, however, since early 2008, the consensus has consistently underestimated inflation (be it on the way up during early 2008 as well as on the way down over the past months). This was evident again today where actual yoy CPI came in at 1.8% (unchanged from the previous month) vs. expectations of 1.5%:
Source: Research Ahead, Bloomberg

Finally, core CPI in the US and the Eurozone has been falling (albeit slowly) on a trend basis since late 2008. However, UK core CPI has been increasing over the course of this year! Usually, UK core CPI is significantly below its US counterpart. But this is not the case anymore and the current difference of +0.3% (UK core CPI of 1.8% vs. US core CPI of 1.5%) is the highest so far this decade.
Source: Bloomberg

This inflation dynamic in the UK is very worrisome and if it continues might force the BoE into an early withdrawal of its massive stimulus despite the ongoing subdued economic state. For the Gilt market this would be a dramatic development as it depends on the substantial buying support of the BoE (via its quantitative easing program). The chart below shows the development of the 10y UK Gilt yield and the 10y Gilt-Bund spread.
Source: Bloomberg

Since the beginning of the year, Gilts have been underperforming. However, the QE announcement in early March led to a substantial tightening in spreads (i.e. UK Gilt outperformance). Thereafter however, Gilts started to underperform again. The early August QE increase announcement seems to have led to a much less pronounced and much shorter-lived UK Gilt outperformance than back in March. So to me this suggests that without the help of QE, UK Gilts would be much cheaper vs. Bunds (in line with the bond-market negative inflation developments). Additionally, I think it will need an increasing amount of QE in order to defy the pressure for Gilt yields to move higher amid the negative inflation dynamics. But this would just mean that the BoE's credibilty would be tarnished further, leading to higher risk premia and weighing on the currency. Overall, this looks highly unsustainable to me and I believe that sooner or later the BoE has to give in and tolerate higher Gilt yields.

Conclusion: I remain seriously worried about an inflationary outcome in the UK (in contrast to the US and the Eurozone) and suggest to underweight the UK from an asset allocation perspective. UK Gilts risk underperforming significantly vs. the US and Eurozone counterparts over the medium term and yields are likely to rise over the next quarters.

Monday, August 17, 2009

Asset Allocation: Kissing the risk-recovery goodbye

Equity markets rallied sharply during the Q2 earnings season of the past weeks and surpassed their early June highs significantly. However, by now they look exhausted and burned-out. Strategically I have been recommending a defensive asset allocation (Asset Allocation: Defensive stance on June 22) but have proposed to lighten up all positions on a tactical basis on July 14 (Market Update: Temporary counter-movement) with the aim of getting back in on cheaper levels. Now, I realign my tactical outlook with the cautious strategic stance as the recovery in risky assets is ending:

Government bonds:
Long duration
Equities: underweight, especially in cyclicals/consumer durables/financials&commodities
Currencies: overweight USD & JPY. Neutral on CHF. Underweight EUR, GBP and commodity-currencies.
Credit: Neutral to moderately underweight credit overall. Within credit overweight higher-rated non-cyclicals (for example utilities) across the curve vs. lower-rated cyclicals.
Commodities: Underweight, mainly energy and base metals but also Gold.
Cash: Overweight

The positive market developments during the Q2 earnings season of the past several weeks was largely down to the positive earnings surprises and the consensus shifting in favor of a marked brightening of the fundamental economic outlook. GDP expectations for Q309 as well as 2010 in general have seen a material upward shift. Additionally, as written here, sentiment towards equity markets has turned largely bullish. For example, according to the American Association of Individual Investors, most US retail investors have become bullish again, for the first time since May 2008. Furthermore, according to ChartCraft's Investors Intelligence, bullish institutional investors outnumber bearish ones by 2:1 and the percentage of bears is back to the lows prevailing in October 2007 (i.e. just when the S&P500 made its all-time high)!
This high level of investor enthusiasm lets me think that by now the positive news is more than adequately priced in. Yes, Q309 should show a markedly positive number in terms of US GDP growth, however, as I have written already previously (Q3 growth likely to surprise positively but not final sales) this should be mainly down to the reduction in the negative contributions from auto manufacturing and residential investment as well as a decline in the pace of inventory liquidation. Furthermore, net exports are likely to contribute positively. Final demand on the other side, does not promise to stage a significant rebound. For one, the positive development of net exports masks that both, imports and exports are falling (just imports are falling more). Furthermore, as US retail sales showed again last week, consumption remains weak. Finally, such weak developments of consumption coupled with the current extremely low level of capacity utilisation will keep business investment depressed.
Additionally, the positive earnings surprises evident for Q2 are more down to cost-cutting than a brighter fundamental backdrop given that revenue surprises painted a much less positive picture. Cost-cutting, however, will further depress future demand growth.

Oil: Upward trend broken, stochastics turn lower from overbought levels
Finally, the market technical picture has been deteriorating over the past days. This is especially evident in some commodity markets as for example oil. The chart above shows that oil has broken through its former upward trend on Friday. Furthermore, stochastics are in overbought territory but have started to fall, also signalling that we are likely at the start of a more pronounced downward-movement.

Overall, I think that markets have discounted a too bright growth outlook, sentiment has become overly bullish and technically markets are starting to fall back from overbought levels. Therefore, I expect a longer-lasting and deeper downturn in risky assets which will also be mirrored by a widening of credit spreads as well as by a sharper downturn in commodity prices. I propose a defensive asset allocation from a strategic as well as a tactical horizon.

Friday, August 14, 2009

Rates Strategy: Relaxed and ready to move

It was a great and really relaxing vacation (which is not self-evident if you have three little boys). So I am ready to move again. If I look at the government bond markets, I get the same impression: They have been on vacation lately but appear relaxed and ready to move. In turn, I update my neutral tactical outlook back to bullish again.

On July 8 (see: Rates Strategy Update: digging below the surface), I adopted a neutral tactical outlook. Timing-wise, however, I first thought that the corrective period might be over by the end of July but subsequently revised that view (see Market Update: near-term risk-recovery not over yet): 'Overall, it seems that the near-term risk-recovery can run further which means that bond prices will also correct lower. While I previously expected this period to be over by the end of this month, there is a clear risk that it might last a bit longer. However, the medium term outlook remains subdued and a renewed period where risky assets and government bond yields move lower - most likely for a prolonged period with more pronounced losses - is likely to start sometimes during August. Therefore, I reiterate once again that I maintain my strategic defensive asset allocation stance but stick to a reduced risk taking on a tactical basis. The 120 area in the Bund future still looks as a good target to open/add to long duration positions.'
Looking back, the Bund future has formed a double-bottom just below 120 (119.92 on July 27 and 119.96 on August 10). This level corresponds to the 50% Fibonacci retracement of the previous upward movement from June 8 (117.47) to July 8 (122.49) at 119.98. Therefore, technically, the Bund future seems to have formed a bottom at the 120 area. Furthermore, the market appears oversold and in turn ready for a bounce following its 5-weeks pause. In the US, the 10y future has erased almost its entire early June-early July gains. However, it did not trade down to new lows and also here the technical situation looks oversold and ready for a bounce. In terms of positioning, the CFCT data indicate that shorts have grown again, especially in 10s and 30s around late July/early August. Additionally, this week's supply is now out of the way (with yesterday's 30y auction surprisingly strong).
Overall, technicals, positioning and supply all suggest that government bonds have been relaxing and are ready to trade higher again from a tactical perspective.
Fundamentally, I do not see that any material changes have taken place over the past weeks which would stand in the way of my subdued medium term growth outlook (I will provide more details on the short and medium term fundamental outlook next week). Inflation has been coming in below expectations (with more downward pressure on core inflation ahead). On the other side, the consensus for near-term growth prospects has continued to improve and earnings surprises have remained equity market friendly in general (less so the revenue numbers, though). Nominal growth rates promise to remain exceptionally low for quite some time which will help government bond yields to remain low as well. Therefore, I do not see any reason to change my bond-bullish strategic outlook. With bond markets having relaxed over the past weeks, I now upgrade my tactical outlook back to bullish again as 10y UST and Bund yields should be able to fall towards the 3% area in the weeks and months ahead.