Monday, October 12, 2009

Rates Strategy Update: Back to neutral

Subsequent to my post on Friday Rates Strategy Update: A first warning shot for the bond bulls, government bonds have sold off into Friday evening with further losses today. On the other side, equity markets are trading to new highs. Furthermore, commodities as measured by the CRB index have broken through a two-months downward trend last Thursday and a move above the August 6 high would suggest that the consolidation period is over. As argued on Friday, it is especially the latter which threatens government bonds as it raises the prospects that a renewed inflation scare might be priced into markets.
To be sure, my fundamental outlook has not changed and I still see very little upcoming inflation pressures. Yes, headline inflation rates will rise over the next months as the base-effects from the previous commodity sell-off into early this year fades. However, core inflation rates should continue to slowly fall further amid the high level of unused capacity (aka the output gap) as well as a credit creation process which is far from working properly. Still, if markets chose to refocus again on the risk of rising inflation, bonds will weaken.
Unfortunately also the latest positioning data raise the propability for lower government bond prices. Last week's JP Morgan investor sentiment survey showed a marked surge of net-longs to 15% from 1% the previous week, a multi-month high. Additionally, pvbp-weighted non-commercial positions in US bond futures (2y, 5y, 10y & 30y) for the first time since late 2008 have moved back to neutral. Non-commercials hold essentially a steepener with longs in 2y&5y vs. shorts in 10y&30y. This short position at the long end of the curve (10y&30y), though, is the smallest since January (i.e. around the time the 10y yield hit its record low). As a consequence, the short-covering by non-commercial accounts promises to be over while the net-longs according to the JPM survey suggests as well that there is little near-term buying in store.
Nr. of net contracts by non-commercials in US 10y futures: Short-covering is over
Source: CFTC

Overall, therefore, the near-term outlook for government bonds has become more uncertain amid the ongoing recovery in risky assets, the renewed surge in commodity prices which raises the threat that markets refocus on the risk of higher inflation and the significant shifts in investor positioning. While sticking to my strategic bond-bullish outlook, I think it is prudent in the light of this uncertainty to move the tactical stance back to neutral for the time being.

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