Fixed Income
Treasury Risks
Actually, let’s start with the bund. Having been bearish from 123.50 to 122.00, we suggested last week a correction to 122.50 in the first instance, a break of which would set up a move to 123.00. Obviously, only the first part of this move took place, with the December contract finding good resistance in the 122.50 area before turning down once again.
However, we feel that the correction which we hoped for last week, will materialise this week. According to the RSI, the bund is clearly in oversold territory, and a short-term bounce to the 121.80-122.00 area is on the cards. This would tie in with a general bounce in global bond markets, after the losses of the past two weeks.
Indeed, despite the yield on the US 10-year rising above the key 4.44% area, to close the week at 4.48%, we think that it can ease back to key support at 4.36%, on a technical basis. That said, beyond the immediate short-term, the risk remains for an adjustment higher in the 10-year yield, taking it above the 4.50% level towards the 4.80-5.00% area, especially with the Fed still in hawkish mode. Despite an encouraging reading for core inflation of 0.1% in September, bringing the y-o-y rate down to 2.0%, the headline figure of 1.2% m-o-m will be a cause for concern. Furthermore, Fed governor Olson has stated that FOMC members are seeing increasing anecdotal evidence of rising pricing power amongst US corporations.
Against this backdrop of inflationary risks, the Fed’s tightening cycle looks set to continue well into 2006, taking the Fed funds rate comfortably above the 4.00% level, and possibly as far as 4.50%, as discounted by the eurodollar curve. Whilst we feel that the whole curve will continue to flatten, the long-end will not escape unscathed from such an adjustment at the short-end of the curve.
The key risk then is that Fed tightening to combat inflation becomes excessive, thereby overly weighing on economic activity, with a clear detrimental impact on house prices, one of the key drivers of the US economy. Our view, though, is that the Fed will prove flexible enough to avoid outright recession. Moreover, the US economy was in good shape before Hurricane Katrina, and should emerge so with some help from the reconstruction effort. Real GDP growth is still healthy, while the labour market is still relatively buoyant. This factor should help to underpin the current dip in consumer spending. In addition, the US corporate sector is benefiting from strong levels of business investment. As such, while there are clear obstacles, and indeed headwinds, for US growth, we do not see it dropping off a cliff just yet, and therefore expect economic activity to stay trending in the right direction.
That said, as the US 10-year yield moves higher, it will become more attractive, which is why we do not think that it will stay high for a prolonged period of time. We do not see global investors turning away from US assets for an extended period of time, and in any case a US 10-year bond yielding close to 5.00% would be too attractive to ignore for Western pension funds.
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