Bunds and UST have continued with their upward trend amid easing inflation fears (on the back of the drop in the CRB index) and a general increase in risk aversion. Interestingly as the chart below shows, US data on average has surprised positively as of late (and I personally also think that the January employment report has rather been a strong one, if judged by the household survey). But that has not been enough to stem the fears of a Greek contagion as well as further monetary tightening measures in China.
US data has surprised positively as of late
Technically, the Bund future has managed to finally break above the 123.50-124 resistance zone where it failed in March 2009, November/December 2010 and in January this year. This highlights that in price terms the bullish medium-term trend remains fully intact! In yield terms, this has not yet been confirmed, however, and 10y Bund yields have not traded to new lows. On Friday, they hit 3.104%, just slightly above the 3.09% reached in early October last year. As long as this support zone is not broken, the diverging price (bullish) and yield trends (sideways) suggest that from a medium-term perspective bullish positions remain warranted (amid rising adjusted future prices) but the absolute performance is subdued amid only a limited yield drop. However, on a more positive note, 30y yields have overcome their early October lows (3.835% vs. 3.82% at present) and trade now at the lowest since mid March last year! Furthermore, also 10y swap rates have traded below their early October lows and have also reached levels last seen in March 2009. This might well be a precursor for a similar break lower in 10y Bund yields.
On the downside, though, following the steady price gains since the start of the year, Bunds are starting to look overbought.
The medium-term technical situation in the US is much more neutral. 10y US Treasury futures so far remain significantly below their highs reached in late November while 10y UST yields remain firmly anchored within the established trading range of 3.95% reached in June and 3.19% reached in early October. Friday's close at 3.57% is exactly in the middle of this range.
Positioning, though, remains heavily tilted in favour of shorts and despite the steady price gains of the past weeks, the close to record-shorts reached in early January have been reduced only by approx. one quarter until the start of February.
Fundamentally, the environment is much more challenging in the Eurozone than in the US where the fiscally induced recovery seems to take hold. The economic woes in the periphery of the Eurozone are spreading and while spreads of Greek government bonds to Bunds have stabilised, peripheral spreads in general have continued to widen given increased fears with respect to Portugal and Spain. I have written on numerous occasions about the subdued outlook for the Eurozoone periphery (see for example No Easy Way out for Eurozone Peripherals). It will take several years to rebalance these economies (restore competitiveness, increase savings ratio, reduce private sector indebtedness etc.). What is more, the ability of the state to support this rebalancing with the help of an easy fiscal stance is fading. Rather, there need to be significant steps of fiscal tightening in conjunction with structural reforms. However, for the domestic economy this will render the situation even more difficult in the short term (but should shorten the overal adjustment period). In turn, the corporate sectors within Greece/Spain/Portugal/Ireland should face a particularly tough environment for several years. Demand by the private sector as well as the government will weaken at the same time (so far only demand by the private sector has weakened), hurting cash-flows. Finally, the ability of the state to continue bailing out the domestic corporates is severly tarnished as well. As a result, the contagion emanating from Greece should not only hit other peripheral sovereigns but much more the peripheral corporate sectors!
I therefore remain of the opinion that for investors being in need of yield pick-up, the corporate sectors of the 'strong' Eurozone countries (i.e. Germany, France, Benelux) offer a more favorable risk-reward than the 'weak' sovereigns and especially than the corporates located in the 'weak' sovereigns.
While it is difficult to forecast the exact timing of the healing process for the periphery, we can be pretty sure that this problem will remain with us for several years and hold back Eurozone growth and inflation during this process. In turn, it will render it a significant monetary tightening by the ECB much less necessary.
Finally, my longer term fundamental outlook has not changed over the past months. I remain convinced that the next several years will on average see subdued growth around a lower trend. However, quarter-over-quarter growth rates should see a heightened volatility with some quarters fairly positive and some showing negative growth rates. This heightened volatility stems from the combination of a lack in a self-sustaining dynamic coupled with an increased reliance on fiscal policy. However, fiscal policy does tend to change in a rather abrupt manner and hence growth will strengthen and weaken signficantly in turn. Inflation on the other side, should not become a major issue, especially in the Eurozone. The lack of credit creation coupled with significant overcapacity suggests that we have still too many goods and not too much money. As a result, nominal growth promises to be low for a prolonged period of time which will keep nominal bond yields at low levels as well.