FI Strategizer : Expect pressure at the long end, especially in the US

Expect pressure at the long end, especially in the US

Since early November, long-term yields have risen sharply in the US, Germany and the UK,although QE measures in the US are still running at full steam and the economic outlook is far from being free of risks.

The rise in yields has been caused mainly by rising inflation expectations, concerns over the public finance picture and a modest improvement in growth outlook. This last factor has led to some portfolio reallocation, and along with the bond sell-off, equity markets rallied in the US, Germany, UK and in Japan.

The short end in these countries has remained anchored by extra-loose monetary policies, leading to a bear steepening. With respect to the eurozone, discussions on possible solutions to the debt crisis will predominate in the first half of the year, possibly keeping risk aversion high and offering some support to long maturity top-rated government bonds, but as the year unfolds we see several sources of risks for Bunds: rising inflation expectations, re-pricing of German credit quality, and the ECB exit strategy.

The short end should remain solidly anchored by expectations that the ECB will not tighten monetary policy until the situation has considerably improved, i.e. end-2011 at best. Money market rates, especially the maturities up to 3M, are likely to remain at currently low levels in relation to the ECB’s recent decision to extend the full allotment. We see MM rates rising only towards the end of the year, as the ECB resumes the exit strategy and possibly prepares to hike rates at the end of the year.

EMU ILBs  BE levels in the EMU are quite cheap, particularly at the 5Y and at the 10Y maturity. Recently, inflation has surprised on the upside, mainly because of developments in energy and core prices. Although risks to inflation in the EMU are comparatively lower than in the US, we would stay long BEs, particularly at the 10Y maturity.

In the US, the Fed QE2 will offset supply of USTs and offer some support to 10Y government bonds until roughly mid-year. We see little chances that the program will be further extended, so in the second part of the year inflation concerns together with a stronger focus on the US fiscal outlook will weigh on long-term USTs.

The 2Y maturity in the US (very much like in the EMU) should remain anchored at around current levels, as the Fed should not act on rates until well into 2012. Similarly, MM rates in the US are likely to remain slightly above the current Fed fund target rate level of 0.25%.

BE inflation has risen considerably in the US from the lows touched during the summer but it is still below the average of 2004- mid 2008. Fed’s QE and relaxed fiscal policy pose the risk of rising inflation expectations. We would stay long BE at all maturities.

The yield curve in Germany, in the US and in the UK will likely remain quite steep formost of 2011, as the short end will remain anchored by steady monetary policy while the long end will be negatively affected by inflation expectations, a possible reduction in risk aversion, growth improvement and the risk of deterioration in credit quality for Germany and for the US.

During the last three years, making the right decisions on country allocation wouldhave been far more important than making the right decisions on duration management. We expect this to remain the case in 2011.  We would start the year underweighting periphery and overweighting Germany, ready to reverse this position if a credible solution to the sovereign long-run solvency issue starts to emerge.

The main risk to our scenario is that the EMU debt crisis deteriorates further and we move first into a full contagion scenario and, if no convincing solution is put forward, we enter either “debt restructuring” or “EMU break-up” mode.  In both cases, monetary policy would have to  remain more accommodative than what we currently expect. Furthermore, the euro would suffer in both cases, possibly leading to inflationary pressure.

UST: we see the long end under pressure

Next year, the Fed will continue with its QE2, at least until June. The decision to extend it or not will depend on the US unemployment data and inflation expectations. Given the strong debate among FOMC members on the effectiveness of QE2, we think that only if the economic outlook remains very weak will the Fed decide to extend the program.  Investors’ focus should progressively move to themes such as inflation and public finance outlook, especially if the fiscal package recently approved by the Senate also gets approved
by the House.

On the growth side, the extension of the Bush tax cuts for another two years and of the unemployment benefits for 13 months could add up to 0.5/1.0pp to 2011 GDP growth.  This, coupled with the Fed still in a QE2 mode and flooding the market with extra liquidity, should support inflation expectations.

The public finance outlook should become a concern next year, if the fiscal package is approved by the House.  Indeed, according to the CBO, the deficit in 2011 should be 9.4% up from the previous estimate of 7%. In 2012 it should be 6.8%, up from the previous estimate of 4.20%.

QE2 has been heavily criticized by the investor community. After the recently approved tax cuts, we expect the Fed to extend QE further only if the economic outlook remains very bleak. Extension of the QE with limited risks of a double-dip recession would be negative for the long end via inflation expectations.

The Fed QE2 program will roughly offset supply of USTs until June, and this should slow down the rise in yields. After June, the Fed support will vanish,  leaving the (moderate) improvement in the business cycle,  inflation concerns and worries about the public finance outlook as the main drivers for USTs.

Public finance has been a main topic recently and so far investors’ focus has been mainly on EMU periphery and, to some extent, on the UK. However, the US is definitely not an example of virtue. We expect the EMU crisis to be progressively addressed next year and, as Europe  (slowly) moves off the stage, the US may (slowly) step in.

We do not expect debate on a possible US downgrade, it is too early  for that, but definitely investors will feel uneasy with a debt/GDP level above 100% and a deficit close to 10%. The timing for such discussions should be 2Q, when investors will also start to anticipate the end of QE2. We thus expect the sell-off on the long end of the Treasury curve to start more decisively in 2Q 2011.

To recap, in the first quarter the risk aversion environment and the Fed’s purchases could still offer some relief to the bond market, especially to the long end. The curve should thus moderately bull-flatten in 1Q as yields retrace after the recent sharp sell-off. Starting from 2Q 2011, the long end should come under renewed pressure. Yields at the short end should increase only moderately given that the Fed should not touch rates until 2012.Hence, we see the case for the US curve staying steep through most of 2011.

In the US, government paper has cheapened vs. swap during the year, around 10bp acrossmaturities and more pronouncedly at the 30Y (+25bp). We expect the 10Y UST to stay under pressure vs. swap also next year, especially in the 2H once the support from Fed purchases is over. At present, the 10Y is trading in the
SW-10bp area, slightly more expensive than around mid-year when it was trading flat vs. swap.  Given the absence of serious plans to tighten fiscal policy, 10Y USTs will probably cheapen to swap +0/10bp next year

EMU: a solution to the sovereign debt crisis is needed 

The key theme in the EMU next year will still be the sovereign debt crisis. After Greece and Ireland received help, now the market expects Portugal to go to the ESFS sooner rather than later, and we see a good probability that it will do so early next year. If this is the case, we think that the aid will be consistent with the Greek and the Irish bailouts, with the country  receiving help until 2014. We see risks that if Portugal will ask for financial aid, investors will “go” for Spain. While we do not think that Spain will also tap EU/IMF funds (fundamentals are better than in the case of Greece, Ireland and Portugal, and the costs both in political and
economic terms would be too high), we expect a considerable amount of spread volatility in 1Q and possibly in 2Q.

The solution to the crisis will be entirely political, suggesting that  the political debate will remain one of the key variables to watch in the EMU.  Where do we stand now in this respect? An agreement has been reached that there will be no restructuring for sovereign debt issued until June 2013.. The main features of the European Stability Mechanism, which should start working from mid 2013, should be:
■ Participation of the private sector to debt restructuring will be decided on a case-by-case
basis, so the mechanism will be less automatic compared to the initial German proposal
■ The ESM may offer loans to Member States if they are deemed solvent (the EU, IMF and
the ECB will carry out the debt sustainability analysis). The loan will be offered under strict
■ The Eurogroup ministers will take a unanimous decision on providing assistance.
■ The ESM loan will be junior only to the IMF.
■ In case a country is judged insolvent, a comprehensive restructuring plan with its private
sector creditors will have to be negotiated.  The ESM may provide then assistance to

However, the debate is far from over. Indeed, at the moment, politicians are still discussing away out of the crisis, but the debate has reached a standstill after Germany rejected both an enlargement of the ESFS (backed by the IMF and the ECB) and the proposal of an E-bond, which would require significant changes in the Maastricht Treaty.

The state elections in Germany will take place in March and Merkel will likely stick to thecurrent tough hetoric until  that date. Hence, we regard as unlikely an easing of  the sovereign debt crisis until at least the second quarter of 2011. Uncertainty and risk aversion are likely to remain high for the first half of 2011.

Hence, there is plenty of scope for markets to keep speculating about an EMU breakup if a convincing solution is not proposed quickly. The EFSF is currently addressing the liquidity  issue, while the solvency issue has not been addressed yet. The insurance against countries’  insolvency at the moment is coming from fiscal austerity and the structural reforms which should help countries improve their growth potential in the medium/long term.

Judging from the latest market developments, investors are still skeptical about the ability of EMU countries to move on a sustainable debt trajectory. This has led to a situation where the only natural buyer of periphery bonds at the moment is the ECB.

The extension of the full allotment coupled with the ECB bond buying program should provide a shelter at least for the first half of next year, but  we see little reason to expect a significant tightening of peripheral spreads at least in the first part of 2011.

First, Portugal will likely be pushed to ask for help early next year, given the challenging bond and T-bill redemption profile in the first part of the year, which would require the country  to front-load much of its activity in the first quarter of the year;  second, a solution for the EMU crisis will take time, especially considering the unfortunate timing of the German state elections.

Third, with Greece below investment grade (and nearly zero chances for an upgrade in 1H), Ireland at the bottom of the investment grade scale and Portugal at risk of more downgrades, it is not clear where demand for these countries’ bonds would come from. A trend that we expect to see next year is that government debt demand will become more local.
There will be another banking system stress test in February, which should be carried  out with stricter criteria compared to this year. This should help to restore some confidence, although the most important issue to be resolved is how to deal with the euro debt crisis.

The first quarter of the year should be moderately positive for Bunds, as uncertainty will still be high and the current German government should keep its tough stance vs. the EMU sovereign debt crisis, so a delay in the crisis’ solution is likely. After 1Q, however, we see several reasons to be Bund negative:
■ Most of the solutions to the EMU sovereign debt crisis are likely to have negative implications for Germany’s credit quality. Both the E-bond solution and the enlargement of the EFSF would ultimately raise the burden of guarantees on Germany, and so would any solution hinting at the creation of a transfer union.
■ A massive intervention by the ECB (defined as weekly purchases in the EUR 100bn area for several weeks)  would probably be the quickest possible solution in case tensions in the financial market deteriorate fast, but this would also push up inflation expectations, at least for the medium and long term, because such a large scale intervention would be difficult to sterilize.
■ GDP will be much stronger in Germany than in the rest of EMU. With the ECB still keeping its extra liquidity measures in place, inflation worries could start surfacing.
■ If a solution to the crisis is found more quickly than expected, the ECB will be ready to resume its exit strategy and prepare markets for a rate hike later in the year.
■ The dynamic in the Bund market should also be influenced by the UST dynamics.As we have argued in one of the previous sections, the long end of the Treasuries curve will progressively be under pressure starting from 2Q. Some spill-over effect will be observed on the Bund performance.
■ The ECB has to remain accommodative because growth undershoots in the EMU periphery, so that it is more difficult to achieve the  deficit targets.  Given the positive growth outlook we expect for Germany, this would be negative for Bunds.

The only scenario where Bunds would benefit is if the crisis deteriorates, leading to an increased perceived probability of a debt restructuring in peripheral countries.

Liquidity should remain abundant in the EMU  for at least the next six months as theECB announced the extension of full allotment at the 3M LTRO until March 2011. This will likely provide a boost for carry trades. The front end of the curve should remain anchored to low levels at least until mid-year because the ECB is unlikely to hike rates until 4Q. We see the 2Y at 1.40% at the end of 3Q and at 1.75% at the end of the year.

Since November, the long end of the German curve has sold off sharply, climbing above the3% psychological threshold. We see this movement as exaggerated. To put things into perspective, consider that 10Y Bund yields have never been above 3% since the Greek crisis, and we are definitely not back to a pre-crisis environment. We thus expect the long end to moderately correct the sell-of in the first quarter of next year, as the market environment will still look risky.

However, the correction should be modest, given that a few other factors will keep thelong end of the German curve under pressure.  We thus see the case for a moderate bull-flattening in 1Q, while in 2Q and 3Q the curve should bear-steepen. The steepening should be more pronounced after June 2011, when the last 3M LTRO will expire and when the Fed will end QE2. In the last quarter, the curve will bear-flatten, as the front-end will start pricing in the first ECB rate hike.

Performance of Bunds vs. swap next year will be influenced by risk aversion (prevailing in the first part of the year)  and by possible repricing of German credit risk (possibly prevailing in the second part of the year). We expect Bunds to cheapen vs. swap
Full report: FI Strategizer : Expect pressure at the long end, especially in the US