Monday, November 30, 2009

Rates Strategy Update: Still in a long-term bull market!

The combination of the Greek and Dubai woes has helped bond markets to perform strongly over the past days. What is more, despite the flight to safety amid rising risk aversion, yield curves failed to steepen over the past days in both, the US as well as the Eurozone. The 2-5y segments flattened whereas 5-10y was range-bound and only 10-30y segments were able to steepen. This should highlight that in an environment where 2y yields are close to or even below 1%, a bull-flattening of the yield curve is difficult to achieve given that the room for yield performance becomes very limited at the short-end. Looking ahead I maintain my bullish tactical outlook with a flattening bias - in line with my bullish strategic view - but admit that especially German Bund yields look expensive on a relative value basis.
First, the technical picture has improved further vs. last week. The adjusted Bund future contract was able to trade to a new high on Friday. The previous high in the roll-adjusted contract was reached on March 9 at 123.57 according to Bloomberg (in unadjusted terms the March 2009 Bund future reached its high on January 15 at 126.53). This is a very positive medium-term signal as it suggests that the bull-trend which started in July 2008 remains intact and the sell-off in spring this year was merely a temporary counter-movement and not the start of a bear market!
Bund future remains in longer-term bull trend
Source: Tradesignalonline, Research Ahead

Also the 2y Schatz future and the 5y Bobl future made new roll-adjusted highs. However, in the case of the Schatz future, Friday's 108.75 level constitutes also a new high in unadjusted terms (vs. 108.625 for the March09 contract reached on March 5 and 108.735 for the Sep09 contract reached on Sep 8). In the US, the 2y future as well reached a new record high in unadjusted as well as in adjusted terms. The 5y future a new high in adjusted terms whereas the 10y future remains below its adjusted high reached on Dec 18 last year.
Overall, bond futures continue to emit bullish signal with the only caveat that they start to look overbought. On the other side, 10y yield charts remain a bit less bullish as both 10y UST and 10y Bund yields continue to trade above the record lows reached early in the year and also above the early October lows. In the case of the 10y Bund yield, the current level of 3.15% compares to an early October low of 3.093%. In turn this would leave the picture neutral. Still, if we look at the underlying bonds (the early October lows were reached with the old Bund benchmark the Jul09 vs. the current benchmark Jan20), then the picture becomes bullish as well. The Bund Jul19 traded down to a yield of 3.054% on Friday, i.e. clearly below its early October lows. Furthermore, shorter-dated yields provide also a more bond-bullish technical picture, especially in the US as 2y UST yields have traded down to 0.67%, i.e. almost back to the all-time lows reached last December at 0.649%.
10y Bund yields break below 3.20-3.40% range but remains above early October lows
Source: Bloomberg, Research Ahead

While the technical picture suggests the bullish movement can run further, valuations look a bit stretched following the significant yield drop of the past two weeks. Judging from the correlation of bonds vs. equities and commodities, especially 10y Bunds appear expensive to the tune of some 20bp (i.e. approx. 2 standard deviations). I see a key reason for this expensiveness in the development of intra-Eurozone government bond spreads. Just as the Greek spreads vs. Bunds have blown out again and took other Eurozone periphery spreads to wider levels, Bunds on the other side moved into expensive territory. This was further accentuated by the Dubai woes at the end of last week. While I do not have a strong view with respect to the developments in the Middle East, I think that intra-Eurozone spreads will not re-tighten back to their levels prevailing at the start of November but rather face more widening pressure over the medium-term and in turn Bunds should remain expensive for some time.
Overall, therefore I maintain my tactical bullish outlook and look for flatter yield curves. However, in light of the expensiveness of 10y Bunds, I would not add to positions anymore at present levels.

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