On Thursday in Last day of Fed Treasury purchases: Do as the Fed does?, I argued once again that nominal growth will be at historically low levels for several years to come given subdued real growth in a stop-and-go economy and amid the lack of inflation pressures. In turn, nominal bond yields should trade at historically low levels as well and I suggested to stick to the strategic long duration positions I started to propose back in June. From a tactical perspective I last downgraded the outlook to neutral from bullish on Oct 12 (see Rates Strategy: Back to neutral). I think that by now, the combination of weaker risky assets, a government bond friendlier macro-view as the V-shaped recovery hopes take a hit and a more supportive positioning environment by non-commercial investors should open the doors for further price gains.
While growth in the US has rebounded sharply from -0.7% in Q2 to +3.5% in Q3, the outlook for Q4 does not look as bright. First in Q3 the impetus on growth by the fiscal stimulus was very significant. However, this does not promise to be repeated in Q4. Remember that for the fiscal stimulus to continue to exert a significant positive impact on growth, it needs to get larger. However, the additional fiscal stimulus in Q4 vs. Q3 does not promise to have that significant an impact on growth. Additionally and as written previously, the summer months were likely to have profited from seasonal adjustments (as argued in more detail here). Given the previous job and output losses, the typical seasonal weakness going into summer was less pronounced resulting in stronger than expected seasonally adjusted data. However, now that summer has ended, the typical seasonal strength should also be less than usual. In short, the people who would normally have been let go for the summer period will not be hired for the autumn rebound as these jobs have been lost irrespective of the seasonal pattern, i.e. on a more medium-term to permanent basis. Therefore, parts of what we perceived to have been good news at the start of the summer was only a technical aberration which is being corrected now as the summer ended. As a result, Q4 growth is likely to surprise negatively vs. consensus and put a dampener on the hopes for a V-shaped recovery.
The latest drop in equity and commodity prices as well helps to ease the upward pressures on bond yields which was apparent during October. Whether especially the weakness in equity markets will be sustained or proves to be just another shallow and temporary setback on the way to new highs remains open. I remain cautious given my fundamental macro-economic view.
Finally, non-commercial investors in US bond futures - which moved to neutral by early October - have scaled back into short-duration exposure over the past three weeks.
In turn, I think that fundamentals as well as positioning open the door for further price gains in government bonds over the next weeks and I move back to a tactical bullish outlook for government bonds.