Fixed Income - Bond Correction:Since the last e-mail, our view of the world has not altered that much. Real GDP growth is still encouraging - as highlighted by the 3.4% figure recorded in the US for Q205 - with small upside risks to inflation. As a result, we continue to like major stock markets, where as bond prices still appear somewhat expensive, for now at least.
In fact, in line with the short-term view we promoted at the beginning of July, global yields have risen over the past couple of weeks, with the key driver being the 10-year US Treasury instrument. As suggested, the yield has risen to the high 4.20s, with 4.28% now acting as key resistance. A break higher would presage a push towards 4.60% over the coming months. Not a high yield on an historical basis, of course, but sufficient to take the steam out of global bond and interest rate markets. On a fundamental basis, the US economy continues to perform well, and while long-term inflation would appear to be contained, there are near-term upside risks due to elevated energy prices and rising unit labour costs. Mr Greenspan himself is concerned by the booming housing market. Against this backdrop, the Fed’s measured approach to monetary tightening will continue. This is putting pressure on the eurodollar futures market, which continues to experience weakness on any strong data release. We have been bearish on the March 2006 contract for a few weeks now, having suggested that a break below 95.80 would set up a decline to 95.50. With the market currently trading around 95.63 (4.37%) we still see scope for further downside.
This weakness in eurodollars is weighing on the euribor market. Regular readers will know that we have been bullish this market for almost a year, having been concerned by euroland growth prospects to such a degree that we have been saying the ECB should cut interest rates, in the absence of any meaningful structural reform. Is it time to change the view? Well, we are not yet convinced that euroland is about to embark on any major economic recovery. That said, there have been some encouraging signs in Germany, where the leap in the July IFO reading indicates that business confidence is picking up, and that therefore growth may rise in H205. As for German exporters, the global economy is still strong, with the US and China leading the way, and the fall in the euro has helped export competitiveness. The sustainability of any recovery, though, will very much depend on the outcome of the September elections. Success for the CDU-CSU coalition led by Angela Merkel could trigger a new reform impetus, which would imply medium-term benefits not just for Germany but for euroland has a whole. However, any multi-party coalition would render the passage of reforms that much more difficult, leaving economic prospects still somewhat bleak. Ok, so let’s stay with the markets for now. Looking at the June 2006 euribor future, the contract is currently testing major support at 97.68. However, if the June 06 breaks below this level we would expect a move towards the 97.50 (2.50%) area.
Any such move would weigh on the bund future, which has so far held the key 121.80 level to which alluded last time around. A further rise in short rates would suggest a re-test of this level for the bund, a break of which would signal a period of further weakness.
On a medium-term basis we have long argued that the search for yield by investors and pension funds together with the US Treasury purchases by foreign central banks will keep global bond yields low from an historical perspective. That said, this short-term correction may well have further to run, as the pressure of rising short-term interest rates takes further toll on the long end of the curve.
Visit Market Opinion [+]
|
