Friday, September 18, 2009

Rates Strategy Update: Decision time draws closer

Since I wrote Rates Strategy: Indecision on Monday 7 September, government bond markets have not done much. The 10y Bund future has been trading around the 121 level with a slight downward bias and the 10y TNote future around the 117 level with a slight upward bias. Technically, nothing changed: So far the 10y UST yield has failed to trade below the 3.304% July yield low on a closing basis while 10y Bund yields still remain in their upward trend which started in January and is currently running at 3.24%. On the other side, 10y Treasury and Bund futures prices remain guided by an upward trend. The combination of a rising 10y Bund yield trend and a rising Bund future price trend, suggests that decision time from this technical perspective is inevitably drawing closer.
From a correlation perspective, 10y yields remain guided by the development of commodities. While gold has been continuing to move higher, the broad commodity indexes remain in their sideways trading behaviour. This suggests that inflationary pressures remain low and explains the ongoing divergence between commodities and government bond yields on the one side (sideways to lower) and equity markets on the other (higher amid the ongoing improvement in the outlook for real growth):
Source: Bloomberg, Research Ahead

I continue to think that while from a cross-market perspective, commodities hold the key for the development of government bond yields, within the government bond universe, 30y UST yields should guide trading. As I wrote in Rates Strategy: 30y US Bond yields send encouraging signal, the US long bond is fighting with a vital 4.10-4.20% area, an area which served as a support several times during the current decade. Theoretically, the long maturity of this bond should render it the most affected by rising risk premia as well as a potential fading of the inflation fighting crediblity of the US Fed and a USD which is seen as a one-way street to eternal weakness. However, so far none of these fears seem to be mirrored by the price action in the 30y. Furthermore, the 30y area remains the least distorted by the buying behaviour of Asian central banks which seem to concentrate on the shorter end of the UST curve. However, also the Fed's own Treasury purchase programme seems to concentrate on other areas. The chart below shows the maturity distribution of the Fed's buying activity up to September 9:
Source: Atlanta Federal Reserve

To quote the Atlanta Fed: "The Fed has purchased a total of $281.3 billion of Treasury securities through September 9. Of the $276.8 billion in non-TIPS securities, the Fed has focused on the four-to-seven-year and seven-to-10-year sectors the most, purchasing approximately $65 billion and $71 billion, respectively. The two-to-three-year and three-to-four-year sectors have also received a fair amount of attention, especially following two large purchases in each sector in late August. The Fed purchased $6.1 billion in the two-to-three-year sector on August 24, $2.3 billion on August 26 in the 17-30 year sector, and $5.6 billion on September 1 in the three-to-four-year sector."
So, up to Sep 9, the Fed has only purchased USD17.3bn in the 17-30y sector. Furthermore, there were only USD 18.7bn left in the overall buying programme. These numbers suggest also that the Fed's UST purchase programme should not be the key reason for the encouraging showing of the 30y US T-Bond and supports my notion that it should be the least distorted instrument across the entire US Treasury curve.

In light of all this, I maintain by bullish tactical outlook for government bonds in line with my strategic view amid a subdued medium-term growth outlook and in line with my expectations of ongoing disinflation in the core CPI rates given a lack of inflation pressures on a short as well as medium term horizon.. I think that 30y US T-Bonds are key and think that the 4.10-4.20% support area should be broken to the downside soon, brightening the outlook for the government bond universe in turn.

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