It is becoming difficult to trade on fundamentals at the moment. The markets are dominated by sentiment which in itself is being driven by political noise.
Firstly, the US Treasury market back up in yields has not been driven by a rise in inflation expectations as would have been expected. In fact forward inflation expectations in the US are not to dissimilar from the start of the 4th Quarter 2012. The past 2 weeks have actually started to see a trend lower in inflation expectations developing.
And in the US this trend will certainly develop as commodity markets weaken and this will bring down front-end inflation expectations as well. It appears the weakness in commodities is being driven by Macro fund selling, reducing their long positions, and also by some dedicated commodity funds suffering significant client withdrawals. Maybe this is a clear sign that the commodity markets were over priced driven by the client expectations of inflation as opposed to real consumer demand. The rise in inflation break-evens this year has been driven more by the back-up in nominal yields than any switching of investors into inflation protected securities. So again there is little to concern those inflation hawks here.
What has been driving longer term US interest rates is nothing to do with the US domestic economy. It has much more to do with politics and fiscal policies in Japan. The new Japanese Prime Minister’s interference in the BoJ’s monetary policy has fuelled an expectation that the Yen will be significantly weakened in the coming months. A target of ¥100/US$ has been set by most FX market strategists.
A foreign currency weakening wouldn’t normally be seen as a catalyst for another government’s bond market to weaken. But in this instance it is being caused by the need of Banks to hedge their interest rate exposure caused by a weakening Yen on the products known as Power Reverse Dual Currency Notes. These notes denominated in Yen were issued to generate high coupons for Japanese investors who were struggling with the low interest rate environment in Japan. During the early 2000’s the Yen did not depreciate as it should have done given the forwards and this allowed the PRDC note market to grow. In the period of 2003 to 2008 issuance of PRDC notes, generally of 30yr maturities, grew massively and is now estimated at around $50bln outstanding. After 2008 when the US Interest Rates fell issuance was switched to be linked to the Australian Dollar.
The impact of this market can be seen in 2008 when the sharp appreciation of the Yen led to the need for Banks to hedge the lower US Interest Rates by aggressively lending in 20yr to 30yr Swaps. Coupled with the unwind of Hedge Funds Carry trades, it forced US Interest Rate Swaps below 30yr US Treasury yields. Now the reverse is occurring. As the Yen rises the Banks are reversing their swap positions and are now paying in 20yr to 25yr US Interest Rate Swaps. How much of this has been done already or continues to be needed is unknown and is fuelling a huge debate in the US Interest Rate markets. But certainly what it has done is push US long dated Treasury yields higher. ¥100/$ is being seen as a level where another bout of hedging is required. How much is the big question and the impact on the market will depend on the market’s positioning at that moment in time. It is perhaps the US Fixed Income Markets biggest focus at the moment.
So the G20 and G7 statements over the past week on the recent currency movements was followed closely by all. The market perception has been that the Japanese have been given the green light to continue with policies that would see the Yen weaken further. However the Japanese had been planning on buying foreign bonds so as to actually require a need to sell Yen in the market. This bond buying program for the time being at least seems to have been shelved. So it appears that the Japanese may well have been put under some pressure to be less aggressive in their policies to weaken the Yen. The Yen has started the week by depreciating further, to 94.22/$ this morning. It will need to be closely followed but with the majority of the market positioned for a weaker Yen it may take longer than the market expects for the Yen to weaken further from here. That opens the possibility for some Yen shorts to be covered with any disappointment at the pace of depreciation.
And given that the market expectation is for a move to ¥100/$ the US Fixed Income Investors have positioned themselves for a further back-up in yields. The JPMorgan US Treasury Client Survey has the largest number of net short positions since July 2011. This certainly isn’t bad news for Treasury markets. August 2011 saw one of the largest monthly declines in 10yr US Treasury yields since the financial crisis started, 83bp. Given the magnitude of the short positions it also should limit any large scale back-up in US Treasury yields as well.
In Europe the weakness in US Interest Rates has pushed German Bund yields higher as well.
The 10yr yield differential between German and US government bonds has remained around 35bp for most of this year. The Bund market has lost some of its flight to safety element as Italian and Spanish bond markets have managed to shrug off political uncertainty in both countries. However it should be noted that both Spanish and Italian 10yr yields are at the same level as they were at the beginning of the year.
There continues to be a positive tone to the peripheral bond markets. After the start of the year’s buying from European Bond funds that still needed to move their fund’s positioning to a more neutral position the past few weeks’ buying has been driven by domestic investors and hedge funds. The Italian elections are next weekend as is the run-off Cypriot Presidential election. The Italian domestic markets are expecting that the centre-left will form the next Italian government. Even if the centre-right parties led by Berlusconi managed to have a strong showing that led to a left wing coalition in the Italian Senate the domestic banks are suggesting that BTP yields will fall modestly. It is this expectation that is leading Italian Banks to buy BTPs on any weakness and preventing Italian Bond yields from rising. However if the centre-left is unable to control the Italian Senate the foreign investor community is more than likely to view this as a weak government that will eventually lead to more political uncertainty. It should be noted that foreign investors aggressively sold when the first polls suggested that Berlusconi was rallying support for his party. In that circumstance any rally in BTPs may well be short lived and Italian Banks that are positioned for a rally may well have to start to sell. A lack of buyers after the elections is the most likely outcome in my view. That would lead to a sharp rise in BTP yields back towards 6% in 10yr and with a weak government coalition the chances of that government accepting the terms of the ESM there will be little chances of the ECB’s OMT program being activated.
This of course would be very Euro negative and once again drive a flight to safety back into German Bunds.
As such, whilst I am cautious about the risks that a further devaluation of the Yen could cause the US Interest Rate market I would remain long duration. However it makes some sense to look to have most duration in long German Bunds and to switch further into German Bunds if the yield differential between 10yr Bunds and 10yr US Treasuries narrows to 25bp.
So for the next week I would expect yields to be range bound. But then I would look for 10yr US Yields to move to 1.80% and 10yr Bunds to move to 1.30%-1.35% by month end.