The press is dominated by the timing of any reduction or cessation in the Fed’s current policy of open ended Quantitative Easing. That means that when any FOMC member makes an appearance than the first reporter’s question seems to be always as to when the Fed will be “tapering” it’s current policy. It was only just over two weeks ago that the Fed in its post-meeting statement added the word “increase” to the phrase “The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes. In determining the size, pace, and composition of its asset purchases”. So why has the market suddenly decided that the Fed will only decrease it’s purchasing and will decrease it’s purchasing before the end of Q3 beginning of Q4 that had been the consensus a few weeks ago.
First the US Employment Report published 2 days later showed a modest improvement ahead of the market’s expectation. But as I said after the announcement the fall in the Unemployment Rate to 7.5% was met with a fall in the hours worked by each employee to 34.4 per week. So the data is not strong enough to see the Fed change its policy. The increase of Non-Farm Payrolls at 165k is actually below the 1yr average of 173k, so it is hardly at a pace that shows a marked improvement in the US economy.
After that the US economic data has been mixed to weaker than expected. The US Consumer has continued to show strength with last week’s Retail Sales above expectations. But even here the growth in Retail Sales is pretty stagnant and certainly not at a pace that would create even trend GDP growth. Then on Friday we had University of Michigan Consumer Confidence- which at 83.7 was the highest reading since Oct 2007. But Consumer Confidence is highly correlated to the equity market and every respondent wants to say that they are benefitting from the rally in the equity market. In fact it was the sentiment for families with an income above $75k, those most affected by equity investments, that surged 17.2 points in May, whilst lower income families only rose 2.6 points. With Wages not going higher, the question remains how is the US Consumer paying for their purchases?
Both Regional Fed Surveys last week were very weak and both moved into negative territory. And Price disinflation continued to be signaled by both the Empire State and Philadelphia Fed surveys although the Phili Fed’s survey saw a slight decrease in the price received component. It has been when the Phili Fed survey has shown negative price received components that the Fed has previously increased its monetary stimulus not decreased it. And again employment in the US Manufacturing base of the North East saw contraction in both employees and hours worked. Not good for the next US Employment report.
This reduction in price pressures is filtering through into inflation measures with CPI and PPI in the month of April seeing a decline in the annual rates to 1.1% and 0.6% respectively. With declines in commodities continuing in the first half of May then it looks likely that the May readings could be even lower. Heating Oil for instance is down 15% since May 2012 and down 5% since the beginning of April. And US Inflation expectations have fallen again and have broken the correlation with Equity markets. US 5yr Inflation Breakevens have fallen to below 2% again and now seem more in line with the moves in commodities.
There is an auction of 10yr TIPS on Thursday of $13bln of the existing TII 0.125 1/15/23 issue. I would expect that dealers will attempt to cheapen the issue ahead of that auction and subsequently lead to lower breakevens. That is supportive for Nominal Bond Yields thsi week.
And so why have US Bond yields been under so much pressure in the past few weeks. It’s Japan. The new round of fiscal and Quantitative Easing has led to an expectation that the Japanese Bond Investors will switch out of Japanese bonds, that they sell to the Bank of Japan, and buy other Government markets, and US Treasuries in particular. So far the affect of the BoJ’s policies has not had the desired effect of lowering Japanese Bond yields. So now US Treasury traders are focusing on the JGB market for direction and also the Japanese Yen. I have spoken before of the market’s fear of huge US Swap paying by Japanese Banks that have entered into exotic swaps to generate extra yield for their investors and in particular the huge Power Rate Dual Currency notes. At the beginning of April there was massive US 20yr to 30yr Interest Rate Swap paying by Japanese Banks as the Yen broke above ¥95/$. the move above ¥100/$ had been expected to generate similar paying. However judging by the moves seen and dealer discussions, it appears that now the Swap paying has not materialised. It appears that the number of PRDC Notes that had a call feature when the Yen broke the ¥100/$ is a lot larger than the market had been expecting and now the need for Paying in the Swaps market will not be affected so much by any further depreciation in the Yen.
Yesterday in an interview the Japanese Economy minister seemed to be suggesting that the Yen would not be allowed to weaken much further. So the prospects of ¥105/$ before the end of the month seems unlikely.
So with all the short positions in the market focused on Japan, then the possibility here is that those shorts do not have a reason to be short anymore. Last week’s JPM Treasury Client Survey had the market participants 38% short their duration target versus only 8% long. the one year average is 27% vs 14% respectively. So there is a very big short base in US Treasuries currently.
And in Europe the weak economic data last week where the German and French economies slowed more in Q1 than had been expected has led to talk that the ECB will lower interest rates at the next meeting on June 6th. The Repo Rate is expected to be cut to 0.25% and the more important expectation is growing that the ECB will move the deposit rate it pays banks from 0% to below zero at -0.25%.
It is mostly Northern European Banks that have deposits with the ECB. It is unlikely that the these banks will choose to take the money off deposit and suddenly lend it to the broader Euro zone economy. More likely and they seem to be doing this already is that they buy German, Finnish, Dutch, French and Austrian short term notes. 2yr German notes, Schatz, now trade at yields below zero. What it will also do is mean that speculative longs in the Euro will be shaken out. It should weaken the Euro against all teh major currencies and this is a continuation of the Central Bank currency wars.
This move to negative Government bond yields in the 2yr area of the curve will eventually feed through to the rest of the Core European Government bond market yields. It has seen 10yr German Bund yields now yielding less than US Treasuries by 60bp as investors start to price in the move to negative short-term yields. It could widen further from here, although in the short term I would favour that the differential narrows to 50bp-55bp as the fears over a tapering of US QE fades. However whatever happens to the it shouldn’t be long before the 10yr German Bund is hitting all time low yields , so sub 1.12%.
My expectations are that the 10yr US 10yr will move back towards 1.75%-1.80% in the short-term and in the next month below 1.60%
Europe will see Core European yields lower with 10yr German Bunds in the middle of next around 1.10%, that would generate a return of around 2%.