Friday, October 9, 2009

Rates Strategy Update: A first warning shot for the bond bulls

On Monday I maintained my tactical bullish bond outlook and suggested that following a brief consolidation, the market would be able to take another leg higher. This is exactly, how things played out in the Bund future. On Monday and Tuesday the Bund future moved slightly lower, losing approx. 30 tics. On Wednesday and Thursday it was able to move higher again and printed a new high above 123 yesterday afternoon. However, the subsequent sell-off raises a warning flag about its future prospects. For one, the 10y US TNote future - while showing the same pattern - was not able to make a new high yesterday. Additionally, the 30y TBond auction was rather poor. Furthermore, several market commentators suggested the sell-off was largely due to comments by Fed president Bernanke. However, I am less worried about his speech and what it might suggest for future policy action than by the latest moves in the commodity area. With respect to Bernanke, he stated that the Fed would be ready to tighten monetary policy when the outlook for the economy "has improved sufficiently". Furthermore, he said "At some point, however, as economic recovery takes hold, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road." To me these statements tell the obvious: Monetary policy accommodation needs to be reduced if the economic rebound is gaining traction (i.e. is becoming self-sustainable). This is always the case. The question is rather, when will that happen (I personally continue to doubt that a meaningful self-sustaining recovery can take hold soon). In turn, given the conditionality of his statements, I do not see any news by Bernanke's comments.
What makes me worried, though, are the latest developments in commodity markets. I used the chart below previoiusly. It shows the development of equity markets (here the EStoxx index), 10y Bund yields and the CRB-index. The EStoxx index and the CRB-index are both set at 100 for March 8 (the day of the equity low) in order to improve readability.
Commodities are sending a warning shot for government bond bulls
Source: Bloomberg, ResearchAhead

As can be seen, government bond yields and commodities exhibited a relatively good co-movement during the past 7 months and both deviated significantly from the equity market performance. I suggested previously (see for example Commodities and related markets to fall first? dated August 26) that equities would be rallying amid the improved outlook for real growth whereas bond yields would be falling amid easing inflation fears which is also evident in the lacklustre performance of commodity prices. Just to repeat, theoretically and empirically it is nominal growth which matters for the level of nominal bond yields. And while the real growth outlook has been improving, expectations for nominal growth have not really moved higher as inflation in general (again, the UK is the big exception) has surprised on the downside. In turn, nominal bond yields were able to fall. Unfortunately, the latest signal being emitted by the commodity complex are looking worrisome for government bonds. Not only do equity markets continue to rise, but now also commodity prices seem to have moved back on a rising path, drawing a wedge between the performance of bond yields and the CRB index (marked in yellow in the chart above).
Looking at the commodity index itself, it seems that it has moved out of a consolidation phase yesterday, breaking a short-term downward trend to the upside while the medium-term upward trend has remained intact (see chart below).
The end of the consolidation period in commodities?
Source: Bloomberg
Furthermore, this move higher is being confirmed by the recent development in the Baltic Dry Index which has also rebounded since the start of this month:
Source: Bloomberg, ResearchAhead

In turn, the prospects of rising equity markets in conjunction with rising commodity prices would constitute a serious headwind for government bonds and currently send a warning flag for government bond bulls and I do take this development seriously. For the time being, I stick with the proposed tactical longs. The reason is that I continue to look for technical factors (see Autumn growth weakness is finally becoming evident) to lead to a relative worsening of the seasonally adjusted economic data for September/October which will weaken the growth recovery story. However, should the CRB index break above its August 6 high at 269.18 while equity markets continue to rally, I would need to reconsider my bullish stance.

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