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Bonds: License To Thrill - June 26
Our two long-time favourite instruments, the bund and the Russian US$ Global 30, acted as we suggested at the beginning of the month. They both moved lower to key support areas around 122.00 and 109.00 respectively before resuming their uptrend. Although we have maintained a bullish view since last year, the fundamentals are still positive.
That said, short-term technicals, particularly on the bund, indicate another period of retracement. The relative strength index points to bearish divergence, while the weak close on Friday could well presage a decline over the coming days. Key support levels for the bund exist at 122.70 and 121.50. In addition, preliminary CPI in Germany rose by 1.9% y-o-y in June, which may well lift inflation for euroland as a whole this month to 2.0% or even 2.1%, from 1.9% in May. No need to panic, we know, but it may cause the market to re-think its bout of euphoria over the possibility of the ECB cutting interest rates. Furthermore, a weaker euro and higher oil prices - which could well spike again over the coming days - may also give the market food for thought, and may indeed deter the ECB from adding a much needed injection of adrenalin to the Western European economy, unless economic activity does slow further from current levels. The Fed too could well continue with its measured pace of monetary tightening this coming week, which would also dent the recent elation of the interest rate futures markets.
That said, the tightening cycle thus far has actually benefited the 10-year US Treasury yield, which is trading below the key 4.0% level, and is showing little sign of spiking to any significant degree anytime soon. Indeed, short-term volatility aside, generally low bond yields are a phenomenon which is unlikely to disappear fast, as we have argued before, due to the huge appetite for low-risk yield from G7 pension funds. In addition, of course, oil producing countries, together with China, are investing large amounts of their huge trade surpluses into fixed income products, another reason why real yields are so low.
Yet, although high oil prices are an upside risk to inflation, we feel that they are more of a risk to global growth, as they act as a de facto monetary tightening for importing nations. As such, the risk for euroland is that inflation stays around 2.0%, perhaps edging marginally higher, while growth slips further, below 1.5%. Against this backdrop, bond yields should continue to stay low.
For now though, as we say above, the bund may well be in short-term overbought territory. Interestingly, the yield on the 10-year German cash instrument appears to have found a base at 3.10%. We would not be surprised to see the yield rise back to the 3.30% level over the coming trading sessions, before resuming its major downtrend.
Emerging Markets Holding Up As for emerging markets (EM) debt, readers will know that we have been positive this asset class for a considerable length of time, and Russia especially. Key for the US$ Global 30 is to take out the 112.00 level, sending the instrument into a new higher trading range. On a long-term basis, as we mentioned in our May 22 article EM Debt Holding On, we are concerned about the ability of the Russian economy to diversify significantly away from oil and other leading commodities. Inflation and growth sustainability are issues which need addressing, as is a lack of investment in oil production and potential restrictions on foreign direct investment into natural resource companies. Much will depend on Mr Putin and any success at real economic development. Also to bear in mind is any uncertainty surrounding the political environment after the 2008 Presidential elections. However, for the foreseeable future, oil revenues are spectacular, and given the record high levels of foreign exchange reserves ensuring that the Russian government is actually a net external creditor, ability to pay debt obligations will continue to underpin medium-term bond valuations. Further Paris Club deals will also add to the positive sentiment surrounding Russian debt.
From an investment perspective, as with the bund, we would be wary of initiating a positive view towards EM debt from current levels, given the rally that has occurred over the recent past. Yet, since we have been bullish for so many months we are comfortable maintaining a positive stance for now. What we are trying to say is that we still like the medium-term macroeconomic fundamentals, but are watching the short-term technicals carefully. In actual fact, the external environment for EM debt has improved too.
The mixed data emanating from the US, which suggests that the US economy may be cooling somewhat, should allow for a continuation of the measured approach to US monetary tightening, worst case scenario. Yet, on the other hand, strong growth in China and India will keep commodity prices high, clearly benefiting EM exporting countries.
The key risk now seems to be a more severe and prolonged slowdown in the developed world due to excessively high oil prices, hitting EM export revenues, and negatively impacting on external accounts. However, in such a scenario, we would expect a price adjustment for EM debt, rather than a bear market. Indeed, the global fund manager search for superior yield would soon resume in earnest.
Turkish Debt Delight We would like to conclude with our recent view of the Turkish US$ Global 30 instrument, which we said on May 22 would trade up to 143.00 on the break above 137.00. Having hit a high of nearly 144.00, it closed the week around 142.875. We are happy to revert to a neutral opinion at this stage, although we still like the idea of Turkish debt trading higher. It has certainly shrugged off all disappointment surrounding the No votes at the French and Dutch referenda, and the underlying macroeconomic and political fundamentals are still very positive. A key risk of late has been the large current account deficit, but we believe that progress on the privatisation front and a general pick-up in foreign direct investment, as Turkish economic ties with Western markets grow, will improve the financing quality of this shortfall. Longer-term, political risks surrounding the EU have, of course, not gone away. In the meantime, though, we would like to see the 30 bond trade above the all-time high at 147.00 before becoming bullish once again.
Commodities
Oil Spikes Again
Our long-held view of oil very much remains. As we have been saying all year, and indeed since Market Opinion came into being last year, oil prices will stay high, with a strong chance of spikes higher. Front month Brent crude has traded up to key resistance at US$58.50/b. If it breaks above this level, hold onto your hats.
The latest rally was due to fears that strong global demand, particularly in China, will strain supply, despite OPEC endeavouring to ease supply constraints. We see no let up in Chinese demand, especially as the OECD has forecast Chinese real GDP growing by 8-10% between now and 2010. Moreover, the IMF predicts that China will import more oil than the US by 2020, and that 25% of global oil demand between 2004 and 2030 will be Chinese.
Iran Risk On the supply side, lack of investment in Russia could well hinder production capabilities going forward, while geopolitical risks in the Gulf remain an ongoing concern. Indeed, aside from the continual violence in Iraq, the outcome of the Iranian elections poses a growing global security risk. The landslide victory of president-elect Mahmoud Ahmadinejad may well remove the moderating policy influence exercised since 1997 by outgoing reformist President Mohammad Khatami. The risk is that the confrontation between the US and Iran over the latter’s nuclear programme escalates. On this point, Ahmadinejad stated during his campaign that relations with the US were not a cure-all for Iran, and that it was his country’s right to develop nuclear technology.
With Iran being the fourth largest oil producer in the world, any rise in tensions with the Bush administration will keep a strong bid under energy prices.
Equities
US Stocks On Key Support
The jump in oil prices, which, as we say, could well spike higher, has brought an abrupt end to recent gains by US, and indeed other G7 stock markets. The prospect of considerably higher energy costs weighing on company earnings has sent the S&P and the Nasdaq to their key respective support levels of 1,190 and 2,050.
Given the extent of the sell-off of the past two trading sessions, we would expect these levels to hold. However, if they were to give way, we would anticipate a difficult period for US equities. If oil prices do spike higher, stock markets are in for a rough ride.
We recently wrote that the German DAX index was at a short-term top, which has proved to be the case. However, we still like the market on a medium-term basis, believing that it can rally to the 5,400 area over the next 6-12 months. For now, though, we are watching key support levels at 4,500 and 4,450. Low interest rates, a weaker euro, and strong foreign investor interest should underpin the market. Long term, though, German, and European economic growth has to show a marked and sustainable improvement.
One market that has caught our eye is the Hang Seng. Whilst much depends on US equity performance, the strong close at the end of the week is encouraging. From a purely technical perspective, any break above 14,300 would suggest further significant gains, possibly towards 16,000.
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