Market Opinion Fixed Income Bonds On The Run

Market Opinion-Fixed Income

Bonds On The Run

Two weeks ago we questioned whether the bond markets had overreacted to the news of Hurricane Katrina, suggesting that the US 10-year yield would find good support in the 3.90-4.00% region before bouncing. Currently trading at 4.27%, the yield has further upside potential in light of ongoing market concerns surrounding US inflation.

The US economy is set to slow during the remainder of the year, due to the social and economic effects of Katrina, somewhere between 0.5-1.0%. The University of Michigan September consumer confidence number fell to a 13-year low of 76.9, from 89.1. However, in light of the reconstruction effort and the strength of the US economy prior to Katrina, a bounce in early 2006 is fully anticipated. The market is focusing on this and the short-term risks to inflation from higher gasoline prices and higher unit labour costs. Both these costs will cause firms to raise output prices to protect profit margins. Against this backdrop, the Fed remains in hawkish mode, and while a pause in the tightening cycle cannot be ruled out, the measured approach will continue. If the Fed were to pause though, we would expect some strong rhetoric on inflation accompanying any such decision. As such, we still see rates heading to at least 4.25% over the coming 12 months.

Yet, as we said two weeks ago, we see no major spike in the 10-year yield, and would expect any move from current levels to be capped short-term in the 4.45-4.50% region, for all the usual reasons - ongoing purchases of US Treasuries by foreign central banks and oil exporting sovereigns, increasing appetite for long-term fixed income products by pension funds, and the low long-term inflationary environment. These dynamics are likely to persist into 2006, although much will depend on the Fed’s controlling of core inflation. On a technical basis, any move through 4.50% in the coming months would trigger upside towards the 4.80% area. Although any such move would likely meet with strong underlying demand.

As for the bund, since we wrote two weeks ago that the instrument was in overbought territory, the December contract has fallen from around 123.15 to its current level at 122.75. Support exists at 122.70. A fall below this would set up a move to next support at 122.40. Key long-term support exists at 121.50.

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