All Good Things Come to an End

I remain sceptical with respect to the economic effects of QE2. Subdued growth is here to stay for a prolonged period in the US as households will deleverage further whereas the government sector has to rein in its deficits over the medium term. Additionally, I don’t expect inflationary pressures to grow meaningfully over the foreseeable future. There is ample spare capacity as can be seen for example by the high unemployment rate and with muted Growth this is unlikely to change soon. Furthermore, the money being created by the next round of QE will likely lead to another significant rise in banks’ excess reserves and in turn not hit the real economy. As a result, there will continue to be too many goods being chased by too little money. The main effect of QE will be to support asset prices/reduce yields. However, the example of Japan has shown that low yields per se do not help much in fuelling aggregate demand or inflation if it does not fuel credit creation (see chart below).

Japanese monetary aggregates and economic activity (avg yoy change 1995-2000)

Source: IMES

In turn, US nominal growth should remain at historically low levels, warranting also low nominal bond yields for an extended period of time. My fundamental fair-value range for 10y UST remains at 2.50-3.00%. I was looking for UST yields to trade around the lower end of this range into autumn and for a low point to be reached during November before yields would be rising to the high end of the range during the winter months. A key reason for this assessment is economic seasonality. During autumn the economy usually re-accelerates following the summer lull. However, as the economy operates significantly below potential, this seasonality should not be as pronounced as is usually the case. In turn, I expected seasonally adjusted data for September and October to come in on the weak side. So far this is indeed playing out and economic data suggests that the US has significantly lost momentum going into autumn. But as the chart below shows with the help of the US employment report data, this seasonal effect is reversing during the winter months with generally weaker economic activity. As a result, I expect that seasonally adjusted economic data will increasingly paint the picture of an improving growth environment for the next few months (especially for December/January).

Economic activity usually weakens during winter

Source: BLS, Research Ahead

Given that the US Federal Reserve is now likely to embark on another round of QE just before this seasonality effect kicks in, the combination an even looser monetary policy with apparently improving economic environment will likely propel nominal bond yields sharply higher, i.e. well above the upper end of my fair-value range. Additionally, the prospects for QE2 have been mirrored by a marked shift in positioning in the UST market. Long duration position as measured by non-commercial longs in the US bond futures market or as measured by the JP Morgan survey of US institutional investors have become rather consensus and are at the highs for the year. Furthermore, whereas the technical picture up to the 10y part of the curve still looks supportive of ongoing yield drops, the developments in the 30y sector are sending a clear warning signal.
The combination of a likely improvement in the macro-economic picture over the next few months, significant long positions as well as a worsening technical picture for ultra-long bonds suggests that the bull-market in UST is likely coming to an end soon. I think that the low pint in 30y UST yields is already behind us whereas for shorter-dated Treasuries this does not yet seem to be the case. I expect yields to continue falling over the next 2-3 weeks amid weakfish economic data and given the upcoming Fed meeting with the likely start of QE2. However, it seems prudent to lighten up on longs already at this point in time and I reducie the long-held UST longs by half, looking to close the remaining longs at slightly lower yield levels over the next 2-3 weeks.

Forming upward trend in 30y UST yield is sending a warning signal

Source: Bloomberg, Research Ahead

Whereas in the US, the technical market outlook is darkening from the ultra-long end, in the Eurozone, it is the short end which has been guiding yields higher. The chart below shows that the 2y Schatz yield marked a low in June and has since been forming on a rising trend. Furthermore, the downward trend which started in June last year has been broken to the upside by now. 10y Bund yields, however, formed their low at the beginning of September and so far have only just broken through the downward trend in place since March this year. I have been looking for such a significant underperformance of German Bunds compared to their US counterparts. The reason for these diverging trends between the US and the Eurozone should be seen in the diverging economic behaviour as well as the clearly different stance of the ECB compared to the US Fed. For one, the Eurozone economy is doing relatively fine amid the strong growth of especially Germany. Furthermore, the ECB does not see further monetary easing as being warranted and seems rather happy about the waning interest in its liquidity provision measures. As a consequence the excess liquidity in the Eurosystem has been dropping significantly, putting upside pressures on ultra-short end yields and leading 3m rates back above the ECB’s 1% repo rate for the first time since mid-2009.

Bearish developments in the Eurozone emanate from the short-end

Source: Bloomberg, Resesarch Ahead

In light of this less accommodative monetary environment and given the ongoing favourable outlook for the North-Eastern Eurozone economies, especially Germany, the fundamental environment in the Eurozone will be increasingly favouring higher yields . As a result, German Bund yields have likely seen their yield lows across the curve and – similar to the US – should rise substantially during the next few months. Amid the tighter monetary environment as I expected initially, I raise my fair-value range for 10y Bunds from 2.25-2.75% previously to 2.50-3.00% and expect a test of the upper end during early 2011. In turn, I would close the remaining long positiions and establish first strategic short duration positions with a view of 3-6 months. The bearish development should be led by the 5y sector of the curve with the 2-5y spread stable to higher and the 5-30y spread likely to move to flatter levels.