Bullish bonds, bad economy

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The strange combination of rising US inflation, ultra-loose monetary policy and falling bond yields is just one of the more unusual signs that all is not well with the global markets. Jennifer Hughes, FT’s senior markets correspondent, looks at the rationale behind so-called “bull flattener” trades and what these signal about the economic outlook.

Please click here or on the image below to watch the video.

Source: Financial Times, August 18, 2011.

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Who will buy Treasuries when the Fed doesn’t? asks Bill Gross

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Bill Gross, co-founder and co-CIO of PIMCO, is to my mind one of the shrewdest money men around. His monthly newsletter, this month entitled “Two-Bits, Four-Bits, Six-Bits, a Dollar”, therefore always makes for thought-provoking reading.

The article can be summarized as follows:

  • A successful handoff from public to private credit creation has yet to be accomplished, and it is that handoff that ultimately will determine the outlook for real growth and stability.
  • Because quantitative easing has affected all risk spreads, the withdrawal of nearly $1.5 trillion in annualized check writing may have dramatic consequences.
  • Who will buy Treasuries when the Fed doesn’t? The question really is at what yield, and what are the price repercussions if the adjustments are significant.

And here are the last two paragraphs:

“By eliminating QE II, the Fed would be ripping a Band-Aid off a partially healed scab. Ouch! 25 basis point policy rates for an “extended period of time” may not be enough to entice arbitrage Treasury buyers, nor bond fund asset allocators to reenter a Treasury market at today’s artificially low yields. Yields may have to go higher, maybe even much higher to attract buying interest.

“Investors should view June 30th, 2011 not as political historians view November 11th, 1918 (Armistice Day – a day of reconciliation and healing) but more like June 6th, 1944 (D-Day – a day fraught with hope for victory, but fueled with immediate uncertainty and fear as to what would happen in the short term). Bond yields and stock prices are resting on an artificial foundation of QE II credit that may or may not lead to a successful private market handoff and stability in currency and financial markets.”

Click here for the full article.

Gross also shared his message in the following CNBC interview:

Sources: Bill Gross, PIMCO – Investment Outlook, March 2011 and CNBC, March 3, 2011.

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Pimco: Inflation poses risk to traditional bond funds

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Chris Dialynas, managing director at Pimco, on why the unconstrained bond fund he manages is short on bonds. He says Pimco’s view is that inflation and rising interest rates pose a risk. The fund has also taken large positions in Asian currencies in expectation of them rising.

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Source: Financial Times, February 10, 2011.

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Government bonds – buyer beware

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“The recent breakout of the U.S. 10-year Treasury yield above 3½% is an important technical signal, highlighting that the macro-backdrop is increasingly turning against the bond market,” said BCA Research in a recent report.

I share the following BCA Research view: “Our global cyclical bond indicators have been bearish for some time and valuation is poor in most of the major countries. The only missing ingredient for a fully-fledged bond bear market is the start of monetary tightening cycles in the U.S. or Europe. Recent comments from Chairman Bernanke, President Trichet and Governor King give us little reason to question our call that the Fed, ECB and BoE are on hold until early 2012. Nonetheless, there is room for the market to discount a faster pace of rate normalization even if central banks do not get started until early next year.

“We are not extremely bearish on government bonds in the near term because the absence of central bank rate hikes should limit the upside for yields in the coming months. Nonetheless, we expect yields to ultimately be significantly higher on a 6-24 month horizon.”

Although bearish in the medium to longer term, a short-term rally in bonds won’t surprise me owing to their overbought condition.

Source: BCA Research, February 9, 2011.

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“Paper money is the wrong thing to own,” says Griffiths

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Robin Griffiths, seasoned technical analyst of Cazenove Capital, shares his views on stocks, bonds and commodities.

Source: CNBC, February 7, 2011.

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Risk-off sentiment refocuses attention on bonds

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The significant sell-off in the long end of the U.S. bond market has at long last resulted in the price of 10-year Treasuries to correctly reflect the state of the underlying economy. Since 1999 the yield on the 10-year Note has narrowly tracked the Conference Board’s Consumer Confidence Index. In the second half of last year the yield dropped significantly below the level of the confidence index. It was either due to the market expecting an imminent double-dip recession or some other forces that were at work. In fact, it was the latter as a result of the culmination of QE1 and QE2 via the repurchase of government bonds by the Fed.

Since 1999:

Sources: I-Net; Plexus Asset Management.

Given the historical relationship between the yield on the 10-year note and consumer confidence it appears that the 10-year note is currently aptly priced at 3.40% compared to the sentiment index at 60.6.

Sources: I-Net; Plexus Asset Management.

The outlook for U.S. bonds undeniably rests on the outlook for the U.S. economy and especially consumer confidence. It is telling me that any weakness in the economy will solemnly be reflected in lower bond rates and a flattening of the slope of the yield curve. Conversely, if the U.S. economy maintains its upward trajectory yields may rise further, resulting in further losses in the bond market.

In the short term, bond prices appear oversold (yields overbought) as shown by the RSI indicator (bottom panel) in the chart below. Lower yields over the next few weeks will be consistent with “risk-off” type of scenario that seems to be unfolding. However, on a longer-term horizon one needs to keep a very close eye on the 28-year downward trend (resistance) line (not shown below) that could be threatened during the next kick-up in yields.

Source: StockCharts.com

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