Market Opinion Fixed Income

Market Opinion
Fixed Income Bund Overbought?

Have the bond markets priced in too negative a scenario for the US economy? If the current gasoline production shortfall lasts only a few weeks, the ongoing tightening cycle is still in place. If, on the other hand, the disruption runs into several months, bond yields could head even lower. It’s a tough call, so let’s look at the technicals.

4.00% is a key level for the 10-year US Treasury bond. A break through this sets up further easing towards the 3.90% area. However, we expect this 3.90-4.00% area to hold and the yield to head marginally higher. Beyond the short-term though, we see no major rise in the 10-year yield, as the instrument remains highly attractive to G7 pension funds, especially when compared to yields of other major bond markets. For example, we would expect any spike to be contained in the 4.40-4.50% area.

As for the bund, it does look overbought on the daily chart, and we expect a short-term period of retracement. Key levels to watch on the downside are 123.75 and 123.30. That said, the medium-term uptrend is still in place. Unlike in the US, there is no doubt in our minds with regards to ECB monetary policy. Rates are most definitely on hold for the foreseeable future, despite the more hawkish tone by Mr Trichet at the latest press conference. Phrases such as ‘upside risks to price stability’ and ‘particular vigilance’ are directing the bias to upping rates on any rise in inflationary expectations.

However, annual CPI fell to 2.1% in August from 2.2% in July. As such, although admittedly money supply growth is strong, inflation is not exactly running out of control. Even Mr Trichet points out that there is no significant build-up of underlying inflationary pressures in the region. Much, of course, depends on the direction of the euro, oil prices and global growth in general.

There is some good news on the economic front. Manufacturing activity expanded for the second month in succession in August, while the EU’s industrial confidence index rallied to –8 from –10 in June. That said, the consumer is still somewhat reluctant to spend money. The EU consumer confidence index was steady at –15 in July, the lowest reading since May 2004. Indeed, the ECB recently lowered its growth forecast for 2005 to just 1.3%, following a drop in real GDP to 1.1% in Q205, from 1.3% in Q1. Hardly an economy that is firing on all cylinders. As a result, the medium-term trend for euribor is still up. Short-term support levels to watch for the June 2006 contract are 97.82 and 97.68, with major trendline support at 97.60. As we said last week, we would only alter our constructive stance of this market on a break below the latter level.

As for UK rates, the unexpected jump in eurodollars last week helped our bullish view of short sterling. However, despite weaker consumer confidence, falling retail sales and slower house price inflation – all of which points to lower interest rates ahead – the short sterling market looks a little overbought near term. Having broken above 95.70, the June 2006 contract rallied as anticipated, hitting a high of 95.82 before consolidating. Strong resistance exists in this 95.80 area. If the market can trade back above this level we would expect further gains towards 96.00. Key support exists in the 95.65 region on any possible retracement. However, despite hitting strong resistance last week, we are sticking with the fundamentals, that the next move in UK rates is down. Then again, seeing as this may not happen for a while yet, especially given recent bullish remarks from the Bank of England, greater value is to be found in the longer dated contracts.

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