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Fixed Income Outlook No.2 - The Basics

Leaving aside for the moment the political sideshow of Europe, Fixed Income markets are undergoing a change in sentiment again.
Falls in commodity markets are now feeding through into inflation expectations in the US. The recent declines in Oil and Metals in particular are signs of a slowing global economy and an exit from investors expectations of higher global growth. US 5yr Inflation expectations have further to fall as well as commodities.

That has fed through as I have shown before into the official Fed surveys in Philadelphia, Richmond and NY State. Note that the Richmond Fed survey is an estimate of the actual rate of inflation, and has prices received at an annualised rate of 0.5%. This decline in inflation expectations has to be worrying the Fed again.

And whilst on its own the decline in inflation expectations does not justify the current yield of 10yr US Treasury, the decline in inflation expectations will cap any rise and with further bouts of risk aversion likely coupled with Operation Twist continuing, it points to lower US Treasury 10yr yields in the short-term at least. In fact given the decline in Inflation expectations 10yr yields should really be re-testing the 1.45% yield lows now.

And it is impacting the bond markets of "Commodity Growth" economies more. The falls in commodity prices will slow the growth in Australia and Canada. As such over the past few months we have seen a reversal in the rise in bond yields of the beginning of the year and now see significant declines and outperformance versus the US Treasury market. 10yr Australian yields were well over 200bp higher than US 10yr Yields in February as the Global Growth optimism was at its highest. Now the yield differential is 140bp, and moving lower. Again it is a sign that Global growth expectations are falling.
It is why we have had Canadian and Australian 10yr and Canadian 5yr bonds in the portfolios. These look likely to continue to perform well in coming months.

And so to Europe.
There has been significant pressure on German Bund markets over the past month. 30yr German Bund yields have risen from 1.62% at the beginning of the month to 2.34% currently. A rout would be a good description. But the selling, initially started by proposed changes to the Pension and Insurance solvency rules which would reduce these investors needs for Bond investments, was added to by speculative Hedge fund selling on the possibility of common Eurobonds where effectively the Germans would guarantee the debts of the rest of the Euro zone. After last night's Euro zone agreement, the chances of Eurobonds occurring within a short-term timeframe seem non-existent. There is a likelihood that the reasons behind these speculative shorts may now dissipate. That would lead to a short-covering rally that if anything could be sharper than the sell-off we have seen over the past month.
10yr Bunds at one stage this morning yielded 2bp more than 10yr US Treasuries. They have recovered nearly a point to now yield 2bp less. However given the likely slower economic growth in Europe, which is now feeding through to Germany, German yields should be significantly below the US, 25bp has been the recent normal level.

So once the optimism disappears again, as it will, 10yr Bunds at 1.61% and even more so 30yr yields at 2.35% look attractive.
Deflation and severe recession are coming to Europe.

Gold is now looking good again- because it has reacted correctly to the fall in Credit Risk Premium of Euro Financial institutions, and as the credit risk rises so will Gold in Euros again. It should also rise in US$ terms as the financial situation in the US will deteriorate as the economy slows again. But the major move will be in Euro Gold. I would look for €1300/toz very shortly.

As always Good Luck.

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