Market Opinion - Fixed Income... Bund Hits Key Support:
Last week we put forward our view of G7 yields. Short term up, medium term still low, especially on an historical basis. Since then, the bund future behaved exactly as suggested. It fell from around 123.06 to support in the 122.10 area, which it held on an end-of week closing basis. The major support level to watch now is 121.80. Immediate short term, the price appears to have stabilised and should push higher. Any drop through 121.80 though, and the next level on the downside is 121.00. The back-up in yields has coincided with the inflationary effects of higher oil prices and a weaker euro. This would indicate that the final E12 HICP June inflation rate is unlikely to differ from the 2.1% estimate. ECB Chief Economist Otmar Issing has also commented that the chances of HICP inflation dropping below 2.0% in 2005 have decreased - although he does see this happening in 2006. For the moment though, this is keeping the ECB from cutting interest rates. Furthermore, ECB Board Member Gonzalez-Paramo stated that price stability is not sufficient to achieve sustained growth, continuing the central bank’s message that the poor growth performance of euroland is due not to lack of monetary policy stimulus but a lack of structural reform. In addition, the bund has come under pressure as US Treasury yields have risen, on the back of strong US data. The 4.20% level for the 10-year instrument holds reasonable importance. A break higher would see a move towards the 4.32% mark. However, in both euroland and the US, inflation is still contained. Furthermore, as mentioned, the outlook for euroland economic growth remains disappointing, with real GDP unlikely to increase by more than 1.4% this year. Moreover, G7 pension funds, together with Asian central banks and oil exporting countries are not likely to refrain from major purchases of G3 bond instruments. The key risk to the bund comes from the strength of the US economy, and the clear potential for short rates in the US to rise faster than anticipated, despite benign levels of inflation. This has been reflected in the eurodollar futures market. The March 2006 contract, currently trading around 95.79 (4.21%) still looks weak, with further declines to 95.70 possible. A break of 95.70 would set up a move to major support at 95.50. That said, fundamentals suggest that the market is pricing in sufficient rate increases. Nevertheless, market sentiment could well take the price action lower. This is the key risk too to euribor and short sterling futures. In both areas, we are expecting the next move in rates to be down. US economic data, though, is providing short term headwinds. EM Debt Although this asset class is still performing well, it has been unable to break through its all time highs, due in large part to the back up in US yields. Going forward, the heavy 2006 election schedule, especially in Latin America, and the likelihood of pre-financing operations ahead of next year may well weigh further on price action. That said, as we have long argued, the improving fundamentals - sustainable growth outlooks, increasing levels of foreign exchange reserves, more comfortable debt dynamics, and sound economic policy - will keep investors looking for sensible yield from instruments that are underpinned by a solid fiscal story. As such, EMBI+ spreads should move lower on a medium-term basis, while higher yielding local debt will see significantly increased inflows. .
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