While there is nothing to suggest a fundamental improvement in the economy, and judging by the latest batch of data the economy is in fact continuing to deteriorate, we have so far seen a substantial sell off in bonds across the curve, with the 2s10s steepening by 11 bps (just in time for the bull flattener bandwagon to enjoy some out-of-steepener rotation pain). So what is the catalyst for the selloff? Francesco Garzarelli's note to Goldman clients titled "Forecast Reached, Risks Now Balanced", in which he implicitly advises to take profits on USTs, sent earlier may provide some clues...
Forecast Reached, Risks Now Balanced August 27, 2010
1. The intervening weeks between this and the previous edition of the Bond Snapshot on August 6 have seen the release of weaker-than-expected US economic data, validating the view that the second half slowdown that we have long expected is now upon us. Government bond total returns over this period have ranged between 0.9% in Japan and 2.9% in Australia.
2. US 10-yr Treasuries are now bouncing around our revised 3-month forecast of 2.5%. The rally was driven by flows into the very long end of the yield curve, with 30-yr yields falling by around 40bp to just above 3.5%. This bull flattening of the US yield curve has prompted similar behaviour in other G-10 yield curves and further afield in EM rates markets, as the search for yield in these other markets has pushed rates to fresh lows. The sharp move in 10-yr German Bund yields towards 2% is notable, as is the rally in intermediate UK Gilts.
3. There are two important issues worth highlighting at this juncture. First, the macroeconomic conditions accompanying the rally in fixed income are very different to those that saw yields reach similarly low levels at the height of the financial crisis. While recession fears were a clear driver at the time, the price action was further augmented by substantial ‘flight-to-quality’ flows emanating from the broad liquidation of risky assets. Although the risk of a ‘double-dip’ recession has increased, our Financial Stress Index shows ongoing normalisation in credit intermediation, lending standards are easing, and overall financial conditions loosening.
4. Second, we are still observing a healthier growth momentum outside the US, and notably in Europe and the emerging markets. This is in sharp contrast to the situation in late 2008, when macro spillovers from the credit crisis were as harsh outside the US as inside. The relative strength of non-US growth (as we and the consensus forecast) is the basis on which our valuation model argues that bonds have become moderately ‘rich’ (1 standard deviation in 10-yr US Treasuries). It is important to recognise, however, that current yield levels are not suggestive of a bond bubble, as some commentators have stated. Using 10-yr Treasuries as a gauge and based on our current economic projections, yields would be deeply overvalued only from 2.25% and below.
5. With these considerations in mind, we believe that the risks to 10-yr UST yields are symmetric around current levels, as they already incorporate our below-consensus views on US growth, and our view that policy rates will end up above the forwards in Europe next year. On our baseline case, yields are unchanged over the next three months, and rise over the next 6 months. The F.I. Snippets from August 13, ‘Growth Holds the Key’, elaborates on these points and sets out in more detail the forces at play which should keep USTs on the knife edge of our 3-month forecast: looser financial conditions, US growth recovery from Q2 21011 and a depressed global bond premium.
6. The rally has also filtered through to Inflation markets, particularly in the US, which has shown the largest downward correction in inflation expectations, with 5-yr inflations swaps shifting down by just under 30bp to around 1.4%. USD swaps are now pricing CPI inflation running at a meagre 50bp over the next year (August 2010 to August 2011).
7. In Europe, 5-yr inflation swaps have also fallen, but to a lesser extent given the very depressed starting point. In the UK, the sell-off has been less pronounced, with less than a 10bp drop. On our view, the UK RPI curve is the most vulnerable inflation market in the G3. We remain bearish on UK inflation (i.e., we expect inflation to print lower than what is reflected in the forwards). Our recommended short 5-yr UK real rates trade hit the stop-loss, as the nominal swap leg of the trade suffered from the general rally in G3 rates, even though UK inflation expectations are drifting lower.
8. Returning to the long end of the yield curve, the correction has been amplified by asset-liability management flows (a tell-tale sign is the behaviour of swap spreads), particularly at the 30-yr maturity in the US. Our calculations suggest that, since the end of last year, defined benefit private pension plan solvency ratios have been deteriorating at a faster pace in the Euro-area (a –22% decline in solvency position) than in the United States (–14%). The absolute levels of aggregate solvency are hard to pin down, primarily because there is no information available on the derivatives overlay. In the US, we would put solvency today broadly at the same level as in July 2009 (and briefly at the end of June 2010, when the S&P touched 1020). Meanwhile, in Holland and Germany combined, the solvency position is at its worst position since March 2009. Interestingly, the UK plans seem to be in a comparatively better position. Again, these estimates should be taken with a pinch of salt, because they are aggregations of possibly very different positions in very different types of plans.
9. Fed Chairman Bernanke speaks today at the Fed’s annual retreat in Jackson Hole, Wyoming at 10:00am EDT. The recent split in the FOMC over reinvestment of the debt principal suggests that the Fed Chairman is likely to be more backward-looking than he might otherwise have been, providing an overview of economic risks going forward rather than elaborating in greater detail on future policy moves. Next week sees a large amount of other important news items in the US, which is likely to move markets: the minutes of the FOMC meeting (which could provide insight on the recent discussions recently), consumption data, the PMI, ADP employment, core PCE inflation, the ISM surveys and the all-important Non-farm payroll number for August. In the UK, we will see data on consumer borrowing, while in the Euro-zone several of the figures for the core countries and overall Euro-zone on consumer confidence, unemployment, CPI and most importantly, PMIs, are set to be released. The ECB is also meeting next week on Sep 2, and we continue to expect no changes to monetary policy.