Saturday, October 30, 2010

Fixed Income: Has the bear market begun?

Bond yields higher for a third week

The sell-off in the bond market continued for a third week – still with little sign of stabilisation. Two-year yields are back at April levels and 10-year yields have taken back much of the decline since mid July.

However, this week the losses were not only to blame on the normalisation of the European money market. Long bond yields in the US also rose as long positions were squared out ahead of next week’s FOMC meeting. In fact, position squaring has been the name of the game in equity and currency markets as well. We suspect that the questionnaire about the size and the impact of QE that the Fed has posted to the primary
dealers has reinforced the sell-off, as it indicates that the central bank is still not firmly decided about exactly how to implement the next round of QEII.

Correction leaves room for lower yields, but not new lows
In the long end we continue to see this as a correction. There are still too many forces in play adding downward pressure on long bond yields, such as the ongoing softening of leading indicators, low inflation and the upcoming Fed QEII to convince us that a bear market has begun. We believe that the correction has left the market more square, which leaves room for lower long bond yields ahead in both the US and Germany.

That said, it is now much less likely that new lows will be reached in German bond yields – in particular in the short end. Even though excess liquidity increased in the 3M LTRO this week and very shorted dated EONIA rates moved lower, there was only a marginal effect on the 2-year German bond yield. It is now very clear that the market is pricing full normalisation during H1 and with a 6M LTRO expiring in November and the final 1Y LTRO expiring in December, it is very difficult to see 2-year yields moving much below 1% again. On the other hand, the upside is limited, as the forward curve is now pricing EONIA O/N at 1% in early Q2.

Danish central bank hikes again
For a second time this month the Danish central bank hiked the current account and the deposit rate by 10bp to 0.6% and 0.7% respectively. The official rate was kept unchanged at 1.05%. The hike arrives with no particular signs of pressure on DKK, but is obviously a response to the rising money market rates in the Eurozone over the past weeks. With very short-dated EONIA rates moving lower the overnight spread is again in favour of DKK, which should keep the central bank sidelined for now. However, if EONIA rates
move higher again – which could be the case when the next LTROs expire – further hikes cannot be ruled out.

Heavy week ahead: ISM, payrolls, FOMC and ECB
The coming week is heavy in terms of data and events, with ISM, non-farm, FOMC and ECB meetings scheduled. While none of these events are marginal, the FOMC will take centre stage. On the back of the recent weeks’ correction the Fed is not expected to disappoint the markets. We think the risk is for lower long bond yields.

Full report: Fixed Income: Has the bear market begun?

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