Market Opinion August 7 2005 Fixed Income Bonds On The Run
Plus ca change. As we have been saying for the past few weeks, US economic growth remains strong, which together with rising unit labour costs, a potentially overvalued housing market and high oil prices is causing upside risks to inflation. As such, US interest rates will continue to rise, in a measured fashion, as will bond yields. In fact, the US 10-year instrument broke through the 4.28% resistance level to which we alluded in last week’s e-mail, triggering further upside to 4.39%. We see a further move higher over the coming weeks towards the 4.50% area, in the first instance. Despite, the attraction of the 10-year instrument to pension funds and certain foreign central banks, the movement occurring lower down the curve is too much for the long end to withstand. Indeed, the March 2006 eurodollar future is acting exactly as we suggested a while ago. The break below 95.80 has caused a significant decline to 95.55, with our downside target of 95.50 clearly in sight. This of course would equate to a Fed funds rate of 4.25-4.50% by March next year. Not an unreasonable possibility, given the fundamental situation of the US economy. Real GDP continues to grow strongly – 3.4% y-o-y in Q205 – while unemployment is trending lower, as evidenced by the latest non-farm payroll figure of 207,000. Against this backdrop, labour market conditions are likely to improve, reinforcing recent positive data on both the manufacturing and non-manufacturing sectors of the economy. This, in turn, could boost growth further over the remainder of 2005. Yet, while long-term inflation is under control, there are short-term risks to the upside. The most recently revised reading of the core PCE price index registered 1.9% in June, which is near the upper end of the Fed’s forecast range of 1.75-2.00%. Mr Greenspan himself reiterated at his congressional testimony in July that the FOMC will be obliged to continue gradually removing monetary accommodation in order to keep inflation under control. With unit labour costs rising and oil prices still bid, we see no let up in the tightening cycle just yet, and therefore agree with the direction the eurodollar market is taking. However, at some point in 2006 the rate hikes will begin to have an effect on economic activity, with a potential cooling of house prices and related consumer spending, particularly as long yields move higher. With this in mind, although we see further downside for eurodollars, they may not be too far away from fair value. For the moment though, market sentiment is bearish, which could also see the US 10-year spike higher than 4.50%. However, when the market is closer to fully discounting Fed action, a US government bond paying well over 4.50% will be an attractive proposition. The US market is leading the way for bonds globally. Indeed, looking at the bund future, it has acted completely in line with our view. From over 122.40 the previous week, the instrument dropped through our key 121.80 level to a low of 121.16. The short-term trend looks lower, with 121.80 now acting as resistance. The short end is also under pressure, with the June 2006 euribor contract falling through the 97.68 level we mentioned last week to trade as low as 97.58. Major trendline support exists in the 97.55 area, a break of which could send the contract as low as 97.25 (or 2.75%). Euroland money market rates are not just being affected by the US alone. German industrial production rose by a stronger-than-consensus 1.4% m-o-m in June, with the manufacturing sector helped by the weaker euro. Furthermore, an index of industrial confidence produced for the European Commission rose from –10 in June to –8 in July. This is the highest reading since March, and gives a certain justification to the ECB’s steady rate policy. Moreover, the estimate for July consumer price inflation came in at 2.2%, up from 2.1% in June. However, any concern on the part of the ECB over inflation is a little overdone. More so than in the US, long-term inflation is under control, with the core annual rate having fallen to 1.4% in June, from 1.6% in May. Furthermore, consumer confidence in the region is low, unemployment remains high and the European Commission has lowered its real GDP growth forecast for this year to 1.3% from 1.6%. This should temper euribor losses going forward.
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