Monday, November 16, 2009

Rates Strategy: Beware of the steepener

In outright terms, 10y Bund and 10y UST futures have both gained half a point since the start of last week. While this performance confirms my view from last week to stick with tactical longs (alongside the strategic long duration view), price developments have remained muted and 10y yields remain stuck in their tight ranges. Relative to equities and commodities, 10y Bund yields have moved back to fair level after having traded almost 25bp expensive at the start of the month (corresponding to 2 standard deviations) as the chart below shows.
10y Bund yields are back to fair levels vs. equities and commodities
Source: Bloomberg, Research Ahead

Furthermore, positioning as measured with the help of non-speculative net positions in the US bond futures remain tilted on the short side, but not extremely so. Therefore, technicals, cross-market factors as well as positioning does not send strong signals for either direction. However, I stick with my tactical bullish view because a) I do not see a sell-signal from any of these factors and b) I maintain the view that fundamental developments are likely not as positive as the consensus would like to have them. I have frequently laid down my view that the major economies lack a self-sustainable dynamic and the summer months have profited from massive fiscal stimulus and the technical help of seasonal adjustments. However, with respect to the latter, autumn should see a partial payback as the usual seasonal acceleration should be less-pronounced, resulting in - on average - weaker than expected seasonally adjusted data. Looking at the Citigroup economic surprise indicators for the US, the Eurozone and the UK seems to confirm that picture as economic surprises have been in a declining trend as of late.
Economic data tends to surprise on the downside as of late
Source: Citigroup, Research Ahead

While in outright terms, not much happened, the yield curve seems to have become a hot topic with a steepening view becoming consensus. Key reasons for an ongoing yield curve steepening can be found in the expectations that short-term rates will be kept low for a prolonged period whereas medium-term inflation pressures would be growing while the shockingly high fiscal deficits raise the riskiness of government bonds, put pressure on the sovereign ratings and increase the probability of a flight out of this asset class. In turn, risk premia for longer dated bonds are expected to rise. Here, Japan stands in the spotlight where amid the sovereign debt approaching 200% coupled with a low savings ratio, credit-default swap rates have doubled to 75bp over the past two months (just to fall back to 65bp on Friday).
However, I am not convinced on fundamental grounds and in terms of positioning think that it has become a crowded trade. First, I frequently argued that the monetary policy transmission mechanism is not yet working properly. While narrow money aggregates have been rising sharply given the lengthening of the central banks' balance sheets, broad credit aggregates are not as banks remain unwilling to lend and especially households unwilling to borrow. Furthermore, spare capacity remains at very high levels. In turn, it will take a long time before we will move in state where there will be too much money chasing too few goods which would result in inflation. Finally, I remain convinced that much of the additional liquidity which central banks have created over the past two years can and will be absorbed relatively easily if the fundamental situation warrants it. With respect to the ever-increasing supply of government bonds, I also see that the deficit numbers are nowhere near sustainable. However, we should not forget that also demand is increasing amid a rising savings ratio and because banks - which do not lend - use the steep yield curve to recapitalise themselves over time as they finance at close to zero rates and invest into higher-yielding longer maturity bonds. The ongoing rise in the level of excess reserves in the US banking system is an indication that this is indeed taking place.
Still, I remain seriously worried with respect to the medium term prospects of the UK. The reasons are the extent of the structural imbalances, the size of the budget deficit as well as my belief that while the investor community can not do without the USD, they can avoid the GBP. The BoE has effectively monetized a third of public spending via its quantitative easing program. Besides the deficit itself, also this sort of financing is clearly not sustainable and only delays the inevitable adjustments. Interestingly, this Asia Times article Which big country will default first? holds a similar view.
Therefore, fundamentally I agree with the steepening view in the UK (and to a lesser extent in Japan) but not in the US and the Eurozone. Moreover, judging from market positioning, non-commercial accounts seem to be heavily involved in steepeners. The chart below shows the risk-weighted net curve positions by non-commercial accounts in US futures. I have added the risk-weighted net positions for the 2y and 5y futures and also the net positions for the 10y and 30y futures. Then, I deducted the net-outright positions and used the difference between the two groups as an indicator of the curve exposure. Currently, in risk-weighted terms the net-positions in the 2y and 5y futures are USD +11.5mln per basispoint and USD -18.8mln per basispoint in 10y and 30y futures. Therefore, in outright terms, the market is short USD 7.4mln per basispoint. Furthermore, we can also say the market has a net steepening position of USD 11.4mln per basispoint (this steepener together with the outright short equals the net position in 10y and 30y futures). The chart below shows the development of the so calculated curve position. As can be seen, steepeners seem to be widely held again and not that far away from the record exposure in late 2008. Given that it seems to be such a crowded trade, I think this warrants caution and I would refrain from steepening exposure in the US and also the Eurozone. Rather, I see a better risk-reward in curve flatteners.
US curve steepening exposure is significant
Source: CFTC, Research Ahead

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