There is more to Deutsche Bank than just that douchey joke of an economist who appears on CNBC every other day to repeat that the November NFP number was irrelevant (incidentally we agree, simply because everything out of the BLS now has the same trustworthiness as Chinese data, and the November number was politically motivated to pass the UI extension) and who changes his story diametrically and on a daily basis, with every incremental piece of economic data that does not fit his amateur theories. Deutsche Bank has always had a very decent fixed income platform, and we are happy to announce that in reading the firm's 2011 FI forecast we encounter not only views that diametrically oppose those of the aforementioned hack (for which alone the report is worth reading), but also has some very detailed and insightful observations (which we are confident David Rosenberg would agree with wholeheartedly). The report's summary: bonds may drop a little more, then surge once it becomes clear the economy is as scroomed as always. And another interesting observation, which has to the do with ending the 10s30s flattener trade. We tend to agree with that as well. Having almost penetrated 100 bps today, the second retest proved unsuccessful, and the time for a steeper long-end is coming (primarily due to a renormalization of the curve), and a flattening of the 2s10s.
2011 Outlook – Higher Yields Are Not Sustainable
- 2010 was a story of expecting low rates, for a long time. We think 2011 will be divided into two halves. The first half represents a test of the low for long view. Is the economy gaining sufficient traction that rates can begin some kind of steady normalization? The second half will be the answer. We think that answer is a resounding no – low for long will come back into vogue. The market will re rally and once again disappoint the economy optimists.
- It is not that the economy isn’t getting better – it is. Instead it is that there are so many headwinds to work through, that recovery is not consistent with premature monetary tightening by either the Fed or the markets. Fiscal stimulus buys time in 2011 but little else. Ironically the stronger growth looks, the more likely fiscal tightening will come into play sooner keeping the recovery on a
- We are closing our 10s30s pain trade flattener. It worked well to protect against a post QE Fed disappointment trade. We feel that this disappointment trade may have a little further to run but the bulk of the move is behind us. We think it is too early to go long duration again but expect to build a new long upwards from 3.35 percent.
- We are also closing our long swap spread trade. This has benefited also from the pain trade and convexity paying. Prospective corporate issuance in early 2011 as well as the surprise fiscal stimulus bodes well for some re narrowing.
- TIPS offer value in the front end out to five years. This is as much due to the fact that breakevens are very low and near term technical factors that can elevate CPI, at least temporarily.
Some notable observations on QE:
The Fed’s QE program is designed to cut through a potentially negative dynamic of expecting falling inflation that feeds into further falls in actual inflation. The proposed new fiscal stimulus and delayed fiscal tightening recognizes the lack of demand stimulators.
While QE is experimental, there is no certainty that it will shock inflation higher. The way QE is being executed also runs the risk of derailing its effectiveness. In trying to raise inflation expectations, bond markets have priced yields higher and mo netary policy appears to have tightened. Defenders of QE hope that yields may anyway have been rising, so net it remains stimulatory but this is open to debate. The only thing for sure is that equities remain higher post QE than pre QE announcement, suggesting some net benefit.
There is always the chance that the Fed shifts gears on QE. If yields rise too much, it may take a more proactive stance and use QE to steer yields lower. Either by focuses on implicit yield targeting or by purchasing more longer dated issues. It could also threaten to increase purchases. We think none of these lucky as long as equities and the economy seem to be on track for some kind of recovery. We think it is unlikely that the Fed will fall short of the $600 billion it intends to purchase even though market speculation as to that possibility will be rife in 2010h1.
And finally, stunningly, a sellsider dares to tell the sad truth about America's dire fiscal situation:
Fiscal policy should raise GDP by at least ¾ percent in 2011, assuming the payroll tax reduction is all spent. However, in our view, at best this buys some time for recovery. The deficit is huge and meaningful fiscal tightening is not far behind. Even if we dodge the Ricardian bullet of equivalence in 2011, there is at least 1 if not 2 percent of fiscal tightening slated for 2012. If underlying economic growth remains in the 2-3 percent range, there is a sharp slowing implied for 2012.
Most market participants recognize the disappointment in the economic recovery. Yet there is quite a diversity of opinions as to what should be done. Our own economists have remained confident that it is only a matter of time before corporates have the confidence to ramp up employment. QE is unnecessary and potentially dangerous for raising inflation expectations excessively. While they have scaled back the timing of Fed tightening they still think it is much sooner than the market currently expects. They interpret the recent sell off in Treasuries as growing confidence in the economic recovery story. The fiscal stimulus, while not expected, adds icing to the recovery cake. The fact that real yields have risen 35 basis points for 10s in less than 5 days is consistent with this view. Breakevens have been broadly unchanged. Our European strategists are more skeptical about the recovery and more concerned about appropriate risk premium in the Treasury market. This reflects the poor score the US attains on a twin deficit monitor. For sure, it is somewhat incongruous that Ireland has to introduce new tax rates for the lowest incomes while the US moves to extend tax breaks for the highest incomes. They conclude that the dollar and yields can’t both be right. Either yields need to be higher or the dollar weaker to reduce the sovereign risk premium.
While these are legitimate concern for the market, we think the outlook for rates in 2011 should also recognize the time consistency of market repricings given the economic backdrop. For example, even if growth does accelerate into the 3-4 percent on the fiscal stimulus, it is not clear to us that the market can sustain forward rates of over 4 percent (3 ½ percent spot) in 10s if fiscal policy is likely to tighten in 2012. As it is elevated rates are choking the housing market again and they may also soon interfere with progress in equities.
So simple, yet so incomprehensible to all those so-called economic pundits...
Full report below: