I have been recommending strategic longs since early June last year in UST and Bunds. The view was based on my outlook for an extended period of historically low bond yields given my outlook for a multi-year environment of low nominal growth amid limited real growth and muted inflation. This still holds and I see no convincing reasons yet to change that view. Broad based credit aggregates are shrinking which will keep inflationary pressures in check. Furthermore, the private sector deleveraging has only just started and promises to run for several years, limiting consumption growth. Finally, the current fiscal deficits are clearly unsustainable be it in the US or in Europe and we will see an increasing number of countries tightening fiscal policy sharply over the next years. Again, this will act as a significant headwind for growth.
However, over the next few months, we are likely to witness a stronger-than-usual seasonal upswing, led by the US. Winter has been strong in the US and most of continental Europe since early December. Cold weather and heavy snowfall have acted to depress economic activity by more than is usually the case during the December-February period. Every year from March onwards, the US and the European economies see a strong seasonal uptick in economic activity as the weather gets more friendly again. This year, given the strong winter, this uptick promises to be even more pronounced than is usually the case. Furthermore, the fiscal easing programmes as well as the accommodative monetary policy are still providing support. This combination promises to temporarily lead to stronger growth going into spring.
As a special factor in the US, we also have the end of the MBS-buying programme by the Fed in March and growing talk about an early implementation of exit strategies (see for example the latest FOMC minutes released yesterday). This might lead to an environment where the ongoing huge Treasury supply will only be digested at higher yields. In turn, I see a large probability that the 10y UST yield will break out of its trading range of 3.15%-3.95% which has been in place since the end of May and move above 4%.
In the Eurozone, the Greek woes (and with that the dismal situation in the periphery in general) will continue to weigh on growth over the medium term. I am convinced that we will see a substantial fiscal tightening in several peripheral countries and the combination of weak private sector demand and weak public sector demand will weigh significantly on overall Eurozone growth. This should also keep the ECB from raising rates in the foreseeable future and leave Bund yields at historically low levels. However, given the EU's signal to provide funds to Greece should it really be necessary, should keep default fears in check. In such an environment, Bund yields will not be able to withstand the upward pressure provided by rising US Treasury yields for much longer. In turn, I expect 10y Bund yields to trade higher within the established range of 3.09%-3.45% with a likely break into the wider 3.09%-3.75% band by June.
In turn, I downgrade my former strategic bullish stance to neutral and on a tactical basis advise to close longs and to adopt a mildly bearish stance for Bunds and a bearish stance for US Treasuries. Finally, I stick to my negative assessment of the UK Gilt market. 10y Gilt yields have already broken out of their former trading range (the UKT 4.75% Mar20 is currently at 4.16% vs. a high in June 2009 of 4.08%) and can rally further.