Fixed Income: QEII done, now what?

QE pushes long bond yields lower again
Over the past week, the bond market has recovered a great deal of the ground lost during the correction in the latter part of October. As we indicated last Friday, the correction did not seem sustainable and we did not believe it was the beginning of a bear trend.

The Fed delivered QE, with the announcement to purchase an additional USD600bn of Treasuries over the coming eight months relatively close to market expectations. One surprise, however, was the distribution of purchases across maturities. The Fed intends to distribute only 6% of its purchases among maturities above 10 years, while 66% of the purchases will be distributed in the 4-10yr segment of the curve. The US bond market has responded by steepening further the 10-30 curve to a new record high.

The ECB meeting had a limited impact on the market. There were no hints about whether the ECB will extend the full allotment policy into next year, but we still expect the central bank to announce this at the December meeting. Indeed, this decision might be supported by rising tensions in the PIIGS markets.

The downward pressure on the 5-10yr segment in the US has rubbed off on the German market, where long bond yields have declined over the past week. Going forward, we do not believe that the QE itself will add significantly more downward pressure on bond yields. To move US long bond yields lower, the market will probably need additional information, which is increasing the likelihood that the QE will be extended in either size or duration. This could either be an insufficient reacceleration in US growth and/or lower US core inflation.

We expect US 10-year bond yields to trade in the 2.25-2.75% range in the coming months. German bond yields are expected to remain in the 2.20-2.60% range.

The PIIGS are back
Concerns about the debt markets in Southern Europe and Ireland have been intensifying lately. This is partly because Ireland’s funding problems are looking increasingly insurmountable and partly because German politicians have been talking about debt restructuring. This has been visible in the market, where sovereigns spreads to Germany have been widening across the PIIGS. Because the spreads have become so wide, the market is now fearing that Ireland will have to activate the European Financial Stability Facility to obtain funding cheap enough to meet its budget requirements.

These jitters have probably already been adding some downward pressure on German bond yields as investors are moving back into safe havens. With EONIA fixings also coming down, this seems to be making some room for lower two-year bond yields in Germany. However, as we have mentioned before, we think downside to two-year yields is limited as the ECB is gradually unwinding its extraordinary measures. Unless the PIIGS debt markets go into meltdown, EONIA rates will probably not return to previous lows. With few scheduled events next week, focus will be on the PIIGS and on the expiry of the ECB’s six-month LTRO.

FX: USD takes the count on QE2
Fed’s QE2 sends the dollar lower – more to come
The Fed’s decision to apply more quantitative easing (QE2) on Wednesday has weakened the dollar against most currencies over the week. EUR/USD has climbed 2%, in line with our expectations. Even though additional monetary stimulus was largely priced in, the knee-jerk reaction was a dollar sell-off as was also the case on previous announcements of quantitative easing.

There are few things to note about QE2: Firstly, the programme is slightly larger (USD600bn) than analysts had predicted (500bn). This suggests that the Fed is committed and knows that it will require substantial effort to spark the recovery. Secondly, the Fed will reinvest proceeds (250-300bn) from maturing bonds. Thirdly, bond purchases will take place over a longer period (eight months) than markets thought (six months). This means that the Fed is on a long journey. Fourthly, the average duration of the bond purchases will be shorter (5-6 years) than expected (10 years). This has resulted in a steepening of the curve. Finally, both the size and the pace of purchases will be subject to regular review and adjusted in light of incoming economic data. This means that there is no clear bias towards providing more stimulus after the second quarter - this will depend on data. Further, adjustment of the size of the purchases can go either way dependent on the incoming data.

We conclude that a significant amount of liquidity will be added to the financial system over the coming months. This is clearly dollar negative. Furthermore, the outlook of low rates for longer fuels demand for risky assets which is negatively correlated with dollar performance.

The ECB remains committed to its exit strategy. Short money market rates in the eurozone remain elevated but can actually rise more if liquidity is being drained further. Hence, we maintain our call for a gradual dollar depreciation over the coming months and maintain our forecast of EUR/USD to reach 1.45 in three months and continue towards 1.50 on the 12- month horizon unless the monetary policy divergence between the Fed and the ECB abates.

Will G20 meeting bring a ceasefire in the currency war?
With Fed having initiated QE2, the battle lines have been drawn ahead of next week’s G20 meeting in Seoul on 11-12 November. China, Brazil and Germany criticized the Fed’s actions on Thursday and a number of Asian countries are preparing to defend their economies against large capital inflows. Financial Times reports that “the renewed tension is likely to complicate US efforts to get leaders of the world’s leading economies [...] to sign up to a new accord promising to limit current account imbalances”.

We don’t think the “currency war” – a phrase invented by the Brazilian finance minister, Guido Mantega – will end next week. We hope that leaders will get more into step and refrain from competitive devaluations and protectionist measures as this will lead to a global welfare loss, but we doubt that it will happen now as countries are too far away from each other at present and disagree on what needs to be done. More power to the IMF is probably the solution, but it is tricky to say what a new IMF mandate should look like. The currency war will probably rage on into 2011.
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