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.

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