Turning Japanese?

This week has seen significant action by the major global central banks. For one the ECB has started buying Spanish and Italian government bonds while the Fed has stated that the funds rate will stay exceptionally low for at least the next two years (Not to forget that the BoJ and the SNB are also injecting liquidity into the financial system to keep their currencies from appreciating ever further).
What are the implications?
1. Banks have already been backstopped since 2008 via liquidity/capital injections/guarantees. This will continue and keep the banking sector afloat. The same now counts as well for the Eurozone sovereigns. Some of the peripherals might technically be insolvent, however, they are all kept liquid by either the EFSF (Greece, Ireland, Portugal) or the ECB as in the case of Italy and Spain (and potentially other sovereigns). Hence, a wave of sovereign defaults is also off the table. In turn, another systemic financial crisis can be called off (at least for now).
2. Nominal bond yields are turning Japanese. As the Fed depresses UST yields and the ECB caps Eurozone peripheral yields, spread products should come back into investors focus. Reasons are that there is no other way to earn yield (given that 5y UST trade below 1%) and as mentioned above the risk of another systemic financial crisis has dropped sharply given the ECB's capping of Italian bonds. Furthermore, the liquidity injections by the ECB, SNB and BoJ (and potentially also the BoE at a later stage) will also fuel the demand for spread products.
3. However, while nominal bond yields are turning Japanese (Low across the maturity and credit spectrum), below the surface the story is vastly different. In Japan nominal bond yields are low because of negative inflation whereas real yields are positive. In contrast, US nominal bond yields are low due to negative real yields coupled with moderate inflation. As an example: 5y Japanese yields are trading around 0,35% with 5y real yields trading around +0,65%, meaning that implied break-even inflation is around -0,3%. In the US, though, 5y UST trade around 0,95% with 5y TII real yields at -0,76% and the implied break-even inflation rate at 1.75%. Hence, the monetary stance in the US is very accommodative on an absolute as well as on a relative basis compared to Japan. In turn, even though the US economy will continue to deleverage over the next few years and with that there will be little self-sustaining growth (personally I think trend growth in the US should have fallen to around 2% and actual quarterly growth number should oscillate around this trend). However, this extreme level of accommodation should prevent the US economy from falling into another recession and from deflation becoming entrenched. Finally, it supports the notion made above: negative real yields will force investors to bring their money elsewhere).

Markit iTraxx Europe Crossover Index: Recent widening likely to reverse again

Source: Bloomberg

Overall, spread products should be the clear winner of the latest policy actions and I expect that the recent widening seen in the credit world will start to reverse again.

Winds of Change

I expect UST and Bund yields to rise into autumn. I am still of the opinion that the US economic slowdown which became apparent over the past months is a temporary phenomenon (see for example Now it's official: A temporary negative supply shock dated June 10). Furthermore, I continue to remain optimistic about the economic outlook for the Eurozone overall and especially Germany, warranting further rate hikes by the ECB. Clearly, though, the Eurozone sovereign debt crisis has put downward pressure on UST and Bund yields as well as on global risk asset prices. But as a second Greek bail-out is ready to be applied (on the basis that the Greek parliament votes in favour of the Medium Term Plan this afternoon), it seems that a near-term default scenario where Greece can not meet its coupon and redemption payments will be averted.
As I suggested in When should Greece default dated May 25, I don't think that the second bail-out for Greece merely amounts to throwing good money after bad money. While Greece will likely need to restructure its debts in a few years' time, a default now would lead to a devastating outcome for the Eurozone overall given the state of the Eurozone banking system and especially given the risk of contagion to the large sovereign debt markets of Spain and Italy. Even though the way forward will remain bumpy for the peripheral Eurozone sovereigns and some important hurdles remain, I think that the peripheral woes might calm down somewhat during the next few weeks and even months. For one, as mentioned a devastating near-term default scenario has become less likely. Additionally, as reports suggests, a sensible roll-over plan for maturing Greek debts is being negotiated between the banks and the various Eurozone states. This roll-over plan should help Greece to partially refinance maturing bonds and the banks to partially reduce their Greek exposure without taking an accounting loss. Even though it might be deemed a selective default by some rating agencies, this solution should help limit the negative spill-over to the other peripheral debt markets.

10y Spain and Italian bond yields propelled higher by Greek default prospects

Source: Bloomberg

Overall, I expect that markets will slowly start to focus again on the underlying fundamental environment. And here I expect the news to become more favourable in the weeks ahead. I remain a proponent that the US economic slowdown apparent over the past months is largely transitory. Seasonal factors, adverse weather, high food and energy prices as well as supply disruptions following the earthquake in Japan have combined to create a difficult environment for the US economy since early spring. However, all of these headwinds are weakening and some even reversing: I frequently mentioned that the US economy should have become less seasonal than has been the case during previous years (given that the seasonal sectors - for example construction and manufacturing - have seen large job losses over the past 3 years whereas non-seasonal sectors such as health care and education have seen job gains) but seasonal factors have become even larger. In turn, seasonally adjusted data should paint too weak a picture during spring and too strong during July/August and winter. High energy and food prices have corrected over the past weeks with the RICI Agriculture Index being down by approx. 15% since early March and its Energy counterpart by almost 20% since early May. Finally, supply disruptions should ease during the next few months as the situation in Japan normalises.
Overall, therefore, the US economy should increasingly show signs of recovery as summer progresses.

CITI US Economic surprise index has stabilised and should turn up again

Source: Bloomberg

In the Eurozone, I expect the German economy to remain very strong. However, also France should see a pick-up in growth. French exports should react positively given that consumption in its main trading partner - Germany - is picking up whereas the economy in its second most important trading partner - Spain - is showing signs of stabilising. Despite ongoing recession in Greece and Portugal as well as ongoing low growth in Italy, aggregate Eurozone growth should remain well above 2%.
Such an environment - increasing risk appetite, improving growth backdrop and higher ECB repo rates - does not bode well for USTs and Bunds. Furthermore, the technical market situation has also worsened over the past few days. The 10y Treasury future broke and closed below its upward trend which was in place since early April. Today also the Bund future and 10y Bund yields followed. The chart below shows the 10y Bund yield. As can be seen, the downward trend has been tested four times since early April. Today it broke above which would trigger a technical sell signal if confirmed on a closing basis.

10y Bund yields break above their 3-months upward trendline

Source: Bloomberg

Finally, adding to the negative outlook for UST is the end of QE2. Even though the Fed will continue to re-invest maturing bonds, the support for the market is clearly dropping. As an example, at the last 7y UST auction, the Treasury sold USD29bn. Dealers bid for USD 62.3bn and were allocated USD 11.4bn. On June 1 (one day after the auction settled), the dealers sold USD 5.4bn back to the Fed in the Permanent Open Markets Operation and a week later sold another USD 3.2bn. Given that the dealers knew they could sell the bonds back to the Fed just a few days after the auction, they were happy to bid large amounts. Now, however, this game is over and we should expect to see a significant drop in dealer bids at upcoming auctions and in turn intensifying price pressures.

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.

Wirtschaftswunder 2.0

The vulnerability of the rest of the Eurozone to sovereign defaults in SGIP is extremely high amid substantial holdings of government debt in the financial sector. However, this danger has been averted for now. On the other side, the real economic fall-out from a long-lasting recession in SGIP should be limited amid low trade flows. For Germany, the combination of historically low nominal and especially real yields and a weaker exchange rate on the one side coupled with the structural reforms performed during the last decade and the high competitiveness being enjoyed by the corporate sector will help growth to become increasingly stronger. Exports are already surging ahead and there is a high probability that domestic demand growth will increase over the medium term from the subdued levels of the past decade. Watch out for growth exceeding 2.5% on average for the next several years.

If you would like to receive the full publication, then please send me a mail on daniel.pfaendler@researchahead.com

Rates Strategy Update: Winds of change

On Mar 9 I proposed a neutral tactical outlook with a bullish tilt but at the same time confirmed that I expect Q2 to be a tough quarter for international bond markets (see Rates Strategy Update: Temporarily back to neutral). I now downgrade both, the tactical and strategic outlook (with a 3months horizon) to bearish.
There are several reasons for this change:
a) bond market seasonality: as written in detail last week (see A look at bond market seasonality dated March 15), especially April historically provides strong headwinds for bond markets.

b) the weather pattern: Winter was severe in the US and large parts of the Eurozone with heavy snowstorms. A strong winter goes hand in hand with weaker retails sales, weaker housing sales and construction. Furthermore, severe winter storms had a temporarily significant impact on traffic. In turn, economic momentum for the December-February period should have been weaker than the underlying trend implies. However, the weather is not responsible for the underlying trend and as the weather normalises, economic momentum should improve again and temporarily be above the underlying trend (as parts of the loss in retails sales/housing market turnover should not be permanent but just have been delayed, i.e. there should be some pent-up demand which will be released once weather conditions have normalised again).
I previously showed a very profitable trading model based on the prevailing temperature for a given month vs. a multi-year average. The temperature is measured in so-called Heating Degree Days (and Cooling Degree Days for the summer months), a population weighted measure for the average temperature prevailing in the US. The model enters a receiving position in the USD 10y swap rate in a month following a colder-than-usual winter month (and warmer than usual summer month) and a paying position otherwise. For more details see for example Here Comes the Weatherman II).

However, there is also a good correlation between the HDD deviation from norm (with a positive number meaning that it is colder than usual and vice versa) and the Chicago Fed National Activity Indicator (the index is a weighted average of 85 indicators of economic activity and seen as a co-incident indicator) as the table below shows.

	HDD deviation from norm	CFNAI
October	49	-0.90
November	-97	+0.14
December	50	-0.50
January	14	-0.04
February	78	-0.64

November - which had unusually cold weather - saw a sharp rise in the CFNAI. However, the cold December and the cold February saw much lower levels of the CFNAI. January - with a close to average temperature - saw a temporary spike in the CFNAI.

However, if we look at weekly HDD data, the temperature prevailing in the US has turned warmer again earlier this month:

Week Ending	HDD deviation from norm
02. Jan 10	19
09. Jan 10	49
16. Jan 10	2
23. Jan 10	-44
30. Jan 10	-7
06. Feb 10	11
13. Feb 10	34
20. Feb 10	16
27. Feb 10	20
06. Mrz 10	15
13. Mrz 10	-24
20. Mrz 10	-28

Overall, March has been warmer than usual so far. If that is not reversed by the end of the month, then the weather would become clearly bond market negative.

c) the end of the Fed's mortage bond buying programme: The Fed will end its bond buying programme at the end of this month. The programme totalled USD 1.25trn and helped bringing mortgage rates lower. As this happened, other potential buyers of such product were looking for yield elsewhere and helped bring credit yields lower. Furthermore, the average duration of mortgage related securities (given that they have a prepayment option embedded) was reduced and likely fuelled a wave of convexity hedging (via receiving in swaps and to a lesser extent also buying of UST). This should have been a factor explaining the tightening in USD 10y swap spreads as the chart below tries to show (it shows the 10y USD swapspread and the Mortgage Bankers 15y fixed rate mortgage yield).

10y US Swapspread and 15y fixed rate mortgage show high correlation

Source: Bloomberg

However, as the massive buying ends while on the other side the supply of bonds will remain, it is likely that MBS yields will have to rise to find new buyers. With that the duration increases again and convexity hedging might move the other way, i.e. into a swap paying position. This should also take swap rates and swap spreads higher again and also exert a rising pressure on US Treasury yields.
d) Technicals: On daily charts, the technical situation in 10y Bunds starts to look overbought. Furthermore, while the previous rallies were accompanied by rising volumes and the setbacks by falling volumes, the latest rally saw volumes declining further in both the 10y Bund future (see chart below) as well as the 10y TNote future. This suggests a changing trading behaviour and puts the latest rally on a weaker footing.

10y Bund future and volume: latest rally is not accompanied by rising volume anymore

Source: Bloomberg

Overall, this suggests that the current rally in bond prices is likely to end soon and should give way to a markedly negative trading environment with a likely significant rise in yields on an end-Q2 view. In light of this, I downgrade my strategic call from neutral to bearish (looking to re-enter longs around the end of Q2) and also change my tactical outlook from neutral with a bullish tilt to outright bearish. UST yields seem more at risk than their Eurozone core counterparts and I expect UST-Bund spreads to continue on their widening path.

A look at bond market seasonality

Currently I have a neutral tactical call with a bullish tilt (see Temporarily back to neutral dated March 9) and a neutral strategic duration call. However, my view is that Q2 will be difficult for international bond markets amid a temporary re-acceleration in growth following a severe winter. Furthermore, bond market seasonality has its strongest negative effects in April, a topic I will explore on below.

When looking at bond market seasonality, several issues arise:
- seasonality studies need a long time history in order to make the results somewhat statistically meaningful (even if one uses 20 years of data, that still gives only 20 data points per month)
- benchmark bond yield histories face the drawback that the underlying benchmarks change over time which distorts the yield history
- bond yields can trend for decades but in a seasonality study one does not want such trends to influence the outcome (for example bond yields have been in a bear-trend over the past 25 years).

One time series which offers itself for a seasonality study are the constant maturity treasury yields (CMT) as provided by the St.Louis Federal Reserve. They go back to 1962. Firstly, this provides a longer than usual time series (49 years of data which, however, is still not that much). Secondly, given that they are CMT yields, they do not suffer from benchmark changes. Thirdly, in 1962 10y CMT were at approx. 4%, i.e. not far away from the current level of around 3.70%.

The chart below shows the average change in basispoints during the various months. In addition, it shows the net number of months during which yields rose in between 1962-2009. As can be seen, during this time period yields rose on average from January to May and fell thereafter until year end. Furthermore, this was not achieved by some outlier months with huge yield changes but rather by a significant larger number of months seeing yield rises than yield falls (from Jan-May) and vice versa especially in June and from September-December.

Strong seasonality in the US 10y CMT rate from 1962-2009

Source: St. Louis Federal Reserve, Research Ahead

To better highlight this seasonality, the chart below shows the p&l from being short bonds from Jan-May and from being long bonds from June-December. As can be expected from the average yield changes, both, the short and the long trade produce significant profits over this time period. What is more, while the long trade only really starts to perform from the early 1980s onwards (i.e. once the structural bond bull-market sets in), the short trade performed during both, the bear-market of the 1970s and more importantly the bull-market of the 80s/90s and 00s.

A bond-bearish move until May seems to be a feature of a bull as well as a bear market

Source: Research Ahead

In order to test for a different behaviour during the Great bull and bear markets, I divided the history in two sub-segments from 1962-1981 (when the yield high was reached) and from 1982 to 2009. The table below shows the average yield changes during both sub-periods. It is interesting to note, that during the bear market, yields on average rose almost throughout the year (except during November) with the largest yield rises in January, February and July. During the bull market, however, the dispersion of average yield changes was much wider (26bp vs. 13bp) and yields fell on average only during 6 months (June and August-December).

Average monthly change during the Great bear market and the Great bull market

Month	Jan62-Dec81	Jan82-Dec09
January	8	2
February	9	1
March	1	8
April	3	13
May	2	0
June	2	-5
July	9	0
August	5	-9
September	3	-11
October	6	-13
November	-4	-11
December	2	-4

Source: Research Ahead

Furthermore, while during the bear market, the average rise in yields in January and February was larger than during the bear market, the average rise in yields for March and April was much higher in the bull market than previously.
Now, if we do not know whether we are in a structural bull or bear market and the above pattern still holds, this would suggest that shorts are most preferable in March and especially April while longs seem to be advisable especially in November. But it also suggests that even if one assumes that the bond bull market has not ended, being invested early in the year does not pay on average and one should be more active in H2 of any given year.
While I do not advise to invest purely on historical seasonal patterns, it supports my stance that Q2 might be a difficult quarter for international bond markets.

Rates Strategy Update: Temporarily back to neutral

I adopted a neutral strategic outlook and a negative tactical outlook on Feb 18(see: Rising risks of a rise in yields). While initially bond yields rose (on the back of the discount rate hike in the US), they have fallen back subsequently and are currently some 10bp lower. I continue to expect especially April and May to provide a challenging environment for government bonds with a likely significant rise in yields into mid-year. Reasons are the adverse winter weather which led to a more pronounced seasonal downswing in economic activity, but should be followed by a more pronounced upswing later on. Furthermore, April and May are usually the cruellest months for bond investors (I will write more on both at a later stage). Finally, while government bond supply will continue unabated, the US Fed's buying of MBS is drawing to an end at the end of this month.
Therefore, I continue to see a pronounced risk of a significant rise in yields over the next months. However, over the next 2-3 weeks, the balance of risk is favouring a different view and I therefore adopt a neutral tactical outlook with a bullish tilt, looking to re-enter shorts at a later stage.
A) Positioning: Short positions have been reduced somewhat since the extremes reached in mid-January. However, they still do not seem to be at a level which historically has been associated with a significant move higher in yields. The chart below shows the aggregated positioning by non-commercial accounts in the US 2y, 5y, 10y & 30y futures (weighted by the respective pvbp of the futures contract). The last data point relating to March 2nd is marked in red.

Aggregated positioning by non-commercial accounts in US bond futures

Source: CFTC, Research Ahead

b) The weather: I have written several times on this subject (see for example: Here Comes the Weatherman II dated Feb 25). Unfortunately, the weather has remained colder than is usually the case going into March. The table below shows the population weighted heating degree days (HDD) per week for the US as well as the deviation from the historic norm for that week. A positive deviation means that there were more heating degree days and in turn the average weather was colder than is usually the case.

Week ending	Heating Degree Days	Deviation from norm
02. Jan 10	222	19
09. Jan 10	256	49
16. Jan 10	211	2
23. Jan 10	164	-44
30. Jan 10	198	-7
06. Feb 10	210	11
13. Feb 10	225	34
20. Feb 10	196	16
27. Feb 10	188	20
06. Mrz 10	172	15

Source: NOAA

The year started colder than usual with a milder period in the second half of January. Thereafter, the weather turned colder again and has remained so for the past five weeks. Again as a reminder a stronger-than-usual winter should be especially bad for retails sales, construction activity & home sales. Given that it seems to last well into March and March is usually a month with a high seasonal acceleration in economic activity, the seasonally adjusted data for early March promise to turn out relatively weak. In turn, bond markets are likely to remain supported for the next 2-3 weeks.
c) Technicals: So far the technical picture does not provide a sell signal. While bond markets were overbought in the midst of February when I suggested a tactical short, this situation has corrected in the meantime and I would consider technicals as largely being neutral with a bullish tilt as the bullish trends in the 10y UST and Bund future contracts remain in place. The chart below tries to highlight this situation for the 10y US future. The bearish trend-line which was about to be formed by the highs reached in late November and early February was broken to the upside whereas the two upward slopinng trendlines (one since July last year and one in place since the start of this year) are still in place.

10y US Treasury future still guided by upward sloping trend

Source: Bloomberg

Overall, I still look for a potentially significant rise in yields during April/May and stick to a neutral strategic view. However, the next 2-3 weeks might rather see a temporary move lower in both, US and Eurozone yields. In turn, I change my tactical outlook from negative to neutral with a bullish tilt, looking to re-enter shorts at a later stage.

Rates Strategy Update: Rising risks of a rise in yields

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.

Rates Strategy Update: Short-term overbought but no sell signal yet

As my wife is still handicapped given the fracture of her right wrist, I am a full-time house husband at present and therefor I am unable to update the blog as frequently as I would like. So here is just a quick update on the rates markets.

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

Source: Citigroup via Bloomberg

Looking ahead, I think that the air is getting a bit thinner for Bunds and USTs given that technically, bond markets start to look overbought. However, so far technicals remain rather positive, especially in the Eurozone, and positioning is still tilted in favour of shorts. In turn, there is no sell signal yet and I stick with my tactical bullish view for the time being, alongside the bullish strategic market outlook.

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.

Greek Fire Part IV

I have written on several occasions (see for example Germany exports its disease Sep 3, No Easy way out for Eurozone Peripherals Oct 30) about the problems facing especially Greece, Spain, Portugal and Ireland and suggested to shy away from respective government bonds (although last time I upgraded the market view with respect to Irish government bonds). I also stated that I dont believe that Greece can enact the necessary heavy dosage of fiscal tightening and structural reforms on its own. On the one side, the extent of the mess is enormous given the size of the fical deficit/debt, the magnitude of the economic imbalances and the low competitiveness. On the other side, the public acceptance for restraint as well as the political power to enact any meaningful change is clearly limited in a country plagued by faulty statstics, a very high level of corruption, a super-sized black economy as well as a generally low inclination to pay taxes.
In turn, Greece needs outside help in the form of carrots (i.e. money) and sticks (to enact structural reforms) and I am convinced that in one way or the other, they will get it even if it wont be called a bail-out (in order to satisfy the Maastricht/Lisbon treaties). While it is difficult to make predictions about what form the support will take and what the timing of any such move will be, the latest press reports have given some clues about the sticks: As this Reuters article states, the European Commission will suggest to Greece to cut nominal wages in the public sector and set a ceiling for high pensions amongst others.
This would amount to little else than what the IMF would demand as well. More importantly, if the EU/Eurozone or a sub-group of EU countries were to lend money to the Greek and do get real structural change in return, it would not necessarily need to be a bad thing for either side. Furthermore, if the conditions for getting any bail-out money are hard enough, then it should not worsen the moral-hazard problematic as the Spanish/Portuguese/Irish/Italian etc. would have strong incentives to take care of their domestic problems on their own before they are faced with a buyer's strike and need to revert to a bail-out as well. Interestingly, Portugal and Spain which always have been in denial over their structural as well as fiscal problems, seem to at least start acknowledging the need for more significant budget cuts.
Overall, I am still convinced that the Eurozone faces a multi-year period of low nominal GDP growth (amid little real growth and only limited inflation). As the pressure to enact significant fiscal tightening measures is growing and as a potential Greek bail-out seems to have strings attached, the probability of such a low-growth outcome remains high.

With respect to market pricing, peripheral spreads have ballooned drastically since the start of the year and my suggestion to underweight Greece, Portugal and Spain has been proven correct. Also the relative assessment of Italy has proven right as Spain is finally trading with a pick-up relative to Italy in the 10y area. But where to go from here? As spreads have been widening, the carry available has been improving. Furthermore, given that Bund yields remain at historically low levels, carry remains an important driver of total returns.

Intra-Eurozone spreads: unprecedented volatility vs. significant carry

Source: Bloomberg

Earlier this year, I suggested to upgrade Ireland back to neutral while remaining underweight on Spain, Portugal and Greece. Structurally, not much changed and the fundamental risk associated with these countries has not diminised materially (but in my view it has also not risen). On the other side, especially the level of Greek spreads is discounting a significant amount of problems down the road. In turn, the risk-reward for investments into peripheral government bonds has improved. I maintain my negative fundamental/structural assessment of these countries but given the current spread levels, I temporarily upgrade the market view back to neutral on a tactical basis.