The US bonds bull trend goes back 20 years, and yields on five-year US treasuries (a more sensitive ...
The US bonds bull trend goes back 20 years, and yields on five-year US treasuries (a more sensitive measure of Fed policy than the 10-year part of the yield curve) are very close to the top end of this bull channel.
The question, therefore, is whether this level will hold and therefore indicate the Fed is close to finishing its current tightening in anticipation of an economic slowdown, or whether the yield will break above the upper end of the long-term trend, causing markets to fear a secular shift in inflation expectations and a more aggressive Fed policy.
The last decade has been one of excessive global liquidity, with the Bank of Japan becoming a large provider to stave off deflation. The Fed has consistently turned on the taps in the face of crises - the Asian crisis, LTCM, 9/11 and the bursting of the equity bubble to name a few - when cyclically investors might have expected tightening. It is easy to argue central banks have a long way to go before global monetary conditions return to the historical norm. Bond markets outside the US remain expensive as the Bank of Japan begins its tightening process with higher interest rates and the European Central Bank, now recognising the export-led recovery is feeding into final demand, accelerates the rise in short rates. All this is likely to slow global demand by the second half of 2007.
However, in the US, there are clear signs the economy is slowing down; most notably in housing activity and prices, to which consumer confidence is highly sensitive. The survey data also suggests both the manufacturing and non-manufacturing sectors are beginning to slow. It is likely the US economy will slow to sub-trend levels by year end and to slow further into 2007 as the lagged impact of higher interest rates in the US takes effect.
Tightening elsewhere, namely China, Japan and Europe could also squeeze global growth next year. The question remains: is elevated inflation in the US a late cycle phenomonen or are there structural concerns? It is more likely the former and inflation should move closer to the Fed's comfort zone later this year as consumer confidence corrects downwards. With real yields now at 2.6% and 10-year nominal treasuries at 5.25%, the value has at last returned to the US bond market. The question for investors is whether or not the next bull market in US treasuries has already started. The troublesome pick-up in inflation has encouraged a wait-and-see attitude. However we believe it has and investors should be extending duration in the US without delay. After all, bond yields usually peak months before the last rate hike.
The message from Fed chairman Ben Bernanke is it now more forecast dependent. US gross domestic product growth forecast for the next six months is set at 2%-2.5% and the market has observed the accumulating evidence of economic slowdown in housing, consumption, employment and even capital spending. This leads many to believe the tightening cycle has run its course.
However, there are concerns the outcome could be worse as the indirect effects of the housing decline materialise.
The fall in inflation expectations indicated by measures of break-even inflation suggest credibility in the Fed has been restored.
As a result, 10-year bond yields could fall quickly back to the 4.5% level in coming months and then test 4% again as the inflation data begins to calm moving into 2007.
US bonds close to top-end of the bull channel
Band of Japan begins tightening process
Outlook positive for US
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Senior Managers Regime
Interest rate outlook unchaged
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