Fixed Income Update 2012-06-21

The Phili Fed survey is now showing that deflation is indeed now a real risk in the US economy. If the Fed hadn't announced an extension of Operation Twist last night, I would have said that they would certainly be looking at additional stimulus as soon as possible. The Survey released today had more Mid- Atlantic companies experiencing lower prices being received for their goods and also now more companies are paying less for materials as well.

This decline in the Phili Fed surveys has seen US Inflation Protected Bonds dramatically underperform today.  5yr Inflation breakevens have fallen 10bp today, and 10yrs are lower by 6bp. Some of this will be the unwinding of QE expectations but most of this will be related to the Phili Fed and the declines also seen in Commodities today.

On top of the bad news relating to the commodity market, the auction of 30yr TIPS this afternoon was poorly received. The auction was covered 2.64 times, which was around the 6mth average, but the clearing yield at 0.52%, was 4bp above the When-issued level just prior to the auction. I am certain that there will be further selling of TIPS and buying of nominals in coming weeks and months.

The weak auction has for the moment paused the rally in 30yr US Treasuries. The auction result led to a quarter point drop in the 30yr US Treasury. As we go into the end of the day, I would expect 30yrs to rally strongly.

The chart below shows that the market's expectations of short-term inflation, 5yrs, looks still  to be too high given the decline in commodity prices seen recently. The slowing global economy is reducing demand and with the prospect of QE3 being delayed at least by the Fed, I would see further declines in Commodities and this will drag Inflation expectations lower as I have been forecasting for most of this year.

So it looks likely that inflation expectations will eventually catch up with 10yr Treasury yields. And if, as I expect, the risk premium remains or even increases as a weakening global economy should do that, the yield of 10yr US Treasuries should test the 1.45% historic lows.

If we get to 1.45% in 10yrs in the next 3 months, that would give you a 7% annualised return. Why do investors keep being told by the press that owning Government bonds can give you little return?

And finally to Gold- as I said before the problem I feared with Gold recently is that it looked to be trading as a risk product. It should be viewed as a safe haven investment. Holding 10% in your portfolio is a safe haven and an insurance against disaster. The fall in Gold has been matched by a decline  in financial credit spreads in both the US and Europe. So the current sell-off is actually a good sign for me and as such I covered my short today, a bit early, but still happily. I am tempted to now move long. There is still probably a chance that longs fuelled by the prospect of QE3 and inflation will be shaken out leading to a further decline, but I would expect that there will be a recovery in Gold as financial spreads come under pressure again.

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