Looks likely we have seen the peak in 10yr US Treasury yields for this month and most likely the quarter.
South Korea surprised the market today with a 25bp cut in its base rate to 2.5%, it follows the earlier than expected cut by the Australian Central Bank earlier this week. Why would Asian/Pacific central banks be cutting rates if the Global economy was set to strengthen?
And yet Global equities markets continue to rise amid the expectation of accommodative monetary policy from Central Banks. I keep listening to equity strategists saying that the bond market is a bubble and everyone should get out of bonds and into equities. But given that the rise in equities continues to be fuelled by the expectation that interest rates will remain low for longer, how can equities be the safe bet? We are in a situation where bad economic data is viewed as a positive by equity investors as it means that Central Banks will continue with monetary easing. But a worsening economic climate cannot be helpful to a company’s bottom line. And if the only thing that is keeping equities higher is that bond yields are so low how can a rise in bond yields be good for the equity market? What I am glad to see however is that retail investors have not fallen for this argument. 3 of the top 4 ETF fund inflows last week were into Bond funds! And although the SPDR S&P 500 ETF saw the biggest inflows- the next three bond ETFs saw a cumulative increase larger than the SPDR S&P 500 and if the US Retail investor really thought that equities were the way forward then the iShares Russell 2000 ETF surely wouldn’t have seen the largest ETF outflows.
The US Treasury market has seen a rise in yields after the US Employment Report from last week- I had been expecting a weak report as most of the Fed Regional Bank surveys had showed no improvement in the employment market since the previous month. So given that March’s report had initially been reported at just 88k I had expected a similar sub 100k number this time. However the March data was revised higher to 138k and therefore the 165k rise in NFP for April was in line with the Fed Surveys after all. But even at 165k in job creation the US economy is hardly booming along. Other data was also in line with those Fed surveys with a reduction in the Average Weekly Hours to 34.4 hrs. That is the same as last October’s and November’s report. So at the start of the 2Q 2013 US workers are working the same amount of hours as at the start of Q4 2012 when Q4 GDP rose just 0.4%. 2nd Quarter GDP will not be released until the end of July with the market expecting something around 1.5%. Over the coming weeks I would expect Q2 GDP estimates to be lowered to around 1% and the economic data released in coming days will be weaker than expected.
However the US bond markets used the higher than expected NFP number to build in a concession for this week’s auctions of new 3yr, 10yr and 30yr US Treasuries. 30yr US Treasury yields are 13bp higher currently than at the time of the Employment report. 30yr yields had hit 3.01% but have seen good real money demand apparently that has seen 3.01% be the top in yields. The 10yr US Treasury yield is 11bp higher currently than the pre employment level. The auction yesterday was seen as a poor auction, as the resulting yield at 1.81% was about 1.25bp above the pre-auction level (a tail). However the auction came after a 5bp rally in 10yr US Treasury yields during the US trading day. Normally in these circumstances a tail in the auction should have been expected. So I didn’t see it as bad as some. Today we have the auction of new 30yr bonds and dealers are struggling to set the auction up well as Core European bond markets have rallied and dragged US Treasury yields lower with them. It could mean that again we see a weak auction but it may come at a lower yield than where we are now. What I would expect though is that Dealers are not going to be long bonds after the auction as Indirect Bidder participation should be high. That is where I would expect the Japanese investor demand to be. So even if the auction has a tail, that is a resulting higher yield above the prevailing pre-auction level, than I would expect any weakness to be short lived.
And look at other bond markets to show that the US Treasury market has sold off more than justified just to build in a decent concession for the auctions. 10yr German Bund yields are just 6bp higher than pre-US Employment report. And also if the Global Growth picture was strengthening as the back-up in 30yr US Treasury yields would suggest than Australian bonds would be weakening more than the US markets. And yet the differential is hardly changed and even after the Australian economy had a stronger employment report than expected itself today.
Even the recent bounce in commodities has not meant that US Inflation expectations should not continue to fall. Especially 5yr Inflation expectations should fall back below 2% and that has to be supportive for 10yr and longer yields. And given that I expect that Q2 Global Growth to be downgraded soon I would expect that commodities will see further weakness as well. So 5yr Inflation expectations should target 1.80% this month.
So I am continuing to be constructive on Duration in bond portfolios.
The new US 10yr came at 1.81% yesterday and that looks to me like the top of the range- 1.81% to 1.60% and German 10yr Bunds look now set for a retest of the historic lows of 1.15% in coming weeks.