Monday, September 28, 2009

Rates Strategy Update: here comes the bull-flattener

In Rates Strategy: decision time drawing closer published 10 days ago I argued that the range-trading behaviour in government bond markets would be drawing to an end and that I expect the break to be on the bond-bullish side with my tactic and strategic outlook remaining bullish. Furthermore, in 30y US bond yield sends encouraging signal dated September 11, I wrote: "Should they overcome this 4.10-4.20% area, then that would be a significant long-term bullish signal for the entire UST market!" On Friday, the US TBond yield has indeed closed below this area at 4.09%! In turn, I see my bond-bullish picture confirmed and reiterate my tactic as well as strategic stance as yields should drop amid a flatter curve.

30y US TBond yield finally broke through 4.10-4.20% support area
Source: Bloomberg

To repeat, I think the US 30y TBond holds the key for the entire US Government bond market as a) it is the least distorted maturity sector and b) given its maturity it incorporates the long-term expectations for growth, inflation and the related risk premia. It is the least distorted part of the US curve as Asian central banks are reported to be most active in the shorter US Treasury notes as well as in TBills, shunning the ultra-long segment. Furthermore, the buying programme of the US Federal Reserve has also not seen large volumes being purchased in the 10-30 year area with USD21bn in the 10-17y area and USD17bn in 17-30y. As of September 23, the Fed has purchased USD USD 289bn out of the planned USD300bn, so the programme is almost finished. Therefore, this should not have affected ultra-long yields significantly. Furthermore, given the long term nature of 30y US Bonds, its trading behaviour should provide insights about long-term prospects for the US economy and its institutions. Amid the high economic uncertainty, ongoing inflation fears, increasing supply pressures and waning credibility of US institutions and the USD as the major reserve currency one should expect that 30y US bonds should fare badly. However, as I have shown in my post on 30y US TBond yields cited above, this is not the case at all. The combination of being the least distorted part of the curve as well as providing information about the long-term expectations and risk premia is the reason why I regard the bullish technical signal being emitted by the US 30y Bonds as so important for the entire government bond universe.

In the Eurozone, 10y Bund futures have followed the 30y US lead and made a new high earlier this morning at 121.91, breaking above the double-top reached on September 2 (121.73) and September 11 (121.74), thereby as well providing a positive technical signal.
Bund future breaks through double-top formed in early September
Source:, ResearchAhead

In yield terms, I maintain my initial target of a 3% level for both, 10y UST and 10y Bund yields, which I first mentioned at the start of June. I expect these levels to be reached over the next weeks, i.e. on a tactical horizon. On a stratetgic horizon of 3-6m, we might see even lower yields ahead. My longer-term structural view remains for a prolonged period of ultra-low nominal yields in line with a prolonged period of low nominal growth rates amid very low inflation rates and only limited real growth on average.
Finally, this bullish momentum should be accompanied by flatter yield curves, i.e. it will be the long areas of the curve which drive the bond market and not the short-term parts. Usually, yield curves bull-steepen and bear-flatten. This is because short-end yields are more volatile than their longer-term counterparts given that in a normal environment central banks conduct monetary policy via changes in short-term rates and because short-term expectations are more volatile than long-term expectations incorporated into long maturity bonds. However, short-end rates cannot fall much further, leaving only limited performance potential for short-term bonds. Furthermore, central banks have been engaging in non-standard monetary policy action (i.e. QE and credit easing). The Japanese experience has shown that in such an environment of very low short-end yields, it becomes the long-end which is driving the yield curve as the volatility in short-end yields drops once they approach the 0% lower nominal bound. As the chart below suggests, the 1% level in 2y benchmark bonds seems to be where this fundamental shift in the behaviour of the yield curve takes place.
Japan: fundamental shift in the yield curve behaviour around 1% in 2y yields
Source: Bloomberg, Research Ahead

In turn, with 2y UST yields trading slightly below 1% and 2y Schatz yields at 1.20%, we should be looking for the yield-curve to bull-flatten in the weeks ahead. Therefore, I recommend long-term bonds (i.e. 10-30y) not only from a duration point of view but also in curve flattening positions relative to the 2-5y area.
Yield curves are likely bull-flattening from their extremely steep levels
Source: Bloomberg, ResearchAhead

Overall, the fundamental outlook for US and Eurozone government bonds remains supportive amid a prolonged period of low nominal growth with inflation pressures weakening further and the current real growth improvement unlikely to be self-sustaining. Technically, the US 30y TBond is sending a strongly bullish signal and also the Bund future is providing an optimistic picture. With a structural shift in the behaviour of the yield curve, we should look for a bull-flattening of the government bond yield curves in the weeks ahead. Stay long!


  1. Daniel,
    Thanks for the post. Do you think this indicates that all is not well in the global economy? Deflation is momentum is gaining speed?

  2. Yes, essentially that is it. Currently, from what I see core inflation pressures are abating further (except in the UK) due to lower capacity usage rates, rising unemployment but also given that the monetary transmission mechanism is still not working as evidenced for example by the ongoing shrinking of M2-M1 and M3-M2 in the Eurozone (i.e. we only have positive growth in M3 given the growth in M1). I would not call the current negative inflation rates in the Eurozone and the US deflation though. This is mostly down to the previous fall in energy prices (which if energy prices stay around current levels will revert again into next year). However, the underlying deflation pressures are still increasing!
    Furthermore, we are nowhere near a state where growth (albeit having improved) is about to become self-sustaining. Furthermore, I am convinced that real trend growth will be lower in the decade ahead. This has also been the case in Japan and Germany following their bust of the housing (and related debt) bubble. As households deleverage, growth is being depressed. Additionally, inflationary pressures will remain low for a prolonged period of time. Personally, I think we will have core inflation rates averaging approx. 0.5% in the US and the Eurozone for the next 5 years. Headline inflation will be more volatile given the volatility of commodity prices but in general should also be below 1%. I would not call this entrenched deflation but rather very low to non-existent inflation with the odd negative core inflation reading.
    In turn, I expect average nominal growth to be around 3% in the US and the Eurozone for the next several years. In such an environment 10y bond yields should be trading around these levels as well.

  3. Dear Daniel, your former colleagues currently argue in favour of peripheral EUR Govies. What is your opinion on that issue?

  4. In general I favor investment grade credit products. I think there will be an ongoing tendency towards tighter spreads amid the need for carry. Within the Eurozone government realm, fundamentally I favour Germany & France given that I think in economics terms they will outperform over the medium term. However, also here the need for carry is a strong spread-depressing factor and will act to tighten spreads further despite relative poor fundamentals of some sovereigns. Overall, I would suggest an overweight in Germany and Italy and be neutral on Spain (amid the poor fundamentals). On the other side I would be underweight in Ireland and Greece amid poor fundamentals and a lack of liquidity despite the yield pick-up. I would continue to overweight covered bonds in general as well.
    I hope to write more on the general spread environment soon (I am busy today as I have to take care of my 2 year old son as the kindergarten is closed).