Fixed Income Update 2012-05-23

The Deflation risk continues to grow. Yesterday's Richmond Federal Reserve Manufacturing Survey was weaker than the market consensus, and similarly to the Phili Fed survey I highlighted last week, will begin to worry the FOMC that deflation is coming back to worry the Manufacturing Industries.

We are back into territory that has triggered further monetary easing by the FOMC in the past and I am sure will mean a lot more discussion of it at the next FOMC meeting on June 20th.

As yet- this rise in deflation or at least disinflation, continues to be relatively ignored by the US Inflation Markets and Equity Markets. But the commodity markets continue to show disinflation.

There is plenty of anecdotal evidence that Chinese demand for commodities is falling off a cliff with talk of deferral or even default on orders in Iron-ore and Coking Coal. Hardly surprising given that its largest export market, (the EU) is moving into one of the deepest recessions in modern times. Now with the prospect that a deal with Iran over its Nuclear program maybe in the offing- Oil is losing the risk premium as well. Oil is closely followed by the US Inflation markets and it maybe this fall that triggers a fall in inflation expectations. I believe that the metals markets are a better signal of inflation and these have already signaled a decline in inflation. It is this that is showing up now in the US Manufacturing Surveys. I keep on showing this graph and I offer no apologies for it. It says to me that with Copper off over 15% in the past year and US wage growth at below 2% and falling, where is the justification for inflation expectations of above 1.5% for 5yrs that are currently priced into the market?

And so further monetary stimulus will come from the US Federal Reserve as it has to fight deflation more than any other economic statistic. The problem is of course, that the effect of QE is weakening, and that they have to be sure its use would be effective.  The continuing and growing crisis in the Euro zone is almost certainly why the FOMC will hold off with further monetary easing at this time. They will wait and if the situation deteriorates, as it has to, that is when they will use one of their last bullets in their arsenal.

And so to Europe, Germany is auctioning a 2yr note this morning with a 0% coupon. The issue will be priced at a slight discount to Par with a yield of almost certainly below 0.1%. Lots of talk as to why anyone would buy this- but it is of course obvious. Buyers of this note are sure that the Euro will not continue in its current form at least. The 2yr note would then appreciate when it is redenominated into the new currency. That is also driving the valuation of the rest of the German Bund market.   It is why there is such a flight to safety into German Bunds. It is also benefitting the US Treasury market and even the UK Gilt market. It is driven by liquidity, but I also favour Canada and Australia. 10yr Australian Government bonds still yield above 3%. An economy that has been shown to be so closely linked with the Commodity markets will surely slow down significantly in the coming year. The yield differential of 140bp to US 10yrs has narrowed from over 200bp at the beginning of March. I was looking for it to get to 150bp to take some profits- but given the weakening Chinese demand for commodities I would expect the differential to move close to 100bp in coming weeks. The Australian Dollar would also weaken so the currency hedge of the bond holding has to be continued.

Somehow French 10yr yields are still trading around 130bp more than German Bunds, but offer so much less Safety!. It is French talk of the issuance of mutually guaranteed "Euro bonds" that is keeping the differential from blowing out . To me it is a sign of real concern that the yield differential hasn't blown out to 150bp at least by now. The trading of French bonds appears now to be solely by domestic investors. The International investors are surely sitting on the sidelines here. But French banks cannot continue to solely finance the French deficit, so demand at French auctions must decline in coming months.  That and what will certainly be a disappointment to the French markets of a "Euro bond" announcement from today's Euro Summit has to mean that French 10yr OAT yields will rise sharply. 3% is easily on the cards.

So I continue to recommend short positions in French 10yr OATS .

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