We’ve been talking about this conundrum for a while: Why have stocks been doing well, against a backdrop of improving macro data, while US Treasuries have seen so little yield lift?
Well in the last few days that’s started to break a bit, but according to Goldman’s Francesco Garzarelli, the play now is to straight-up short 10-year US Treasuries.
Go Short 10-yr US Treasuries
Since the end of last August, we have argued that 10-yr US Treasury yields would not be able to sustain levels much below 2% in this cycle. Yields have traded in a tight range around an average 2% since September, including so far into 2012. We are now of the view that a break to the upside, to 2.25-2.50%, is likely and recommend going tactically short. Using Mar-12 futures contracts, which closed on Friday at 130-08, we would aim for a target of 126-00 and stops on a close above 132-00. Our rationale is as follows.
At this stage of the cycle, growth expectations are in the driver’s seat: The value of intermediate maturity government bonds can be related to expectations of future policy rates, activity growth and inflation, and a ‘risk factor’ highly correlated across the main countries. These simple relationships are captured by our Sudoku econometric framework for 10-yr maturity yields. In coming months, we expect effective overnight rates to remain close to zero in the main currency blocs (US, Japan, Euroland, and UK) and retail price inflation to hover around 1.5-2.0% – consistent with the forwards and central banks’ objectives. With policy rates and inflation ‘dormant’ at this stage of the business cycle, bond yields (and the 2-10-yr slope of the yield curve) will likely react mostly to shifts in growth expectations.
Bond valuations are already stretched relative to consensus growth expectations: Around the turn of the year, the outlook on economic activity was buffeted by cross-currents reflecting the adverse credit conditions in the Euro area on the one hand, and the upward revisions to US GDP growth on the other. Our Sudoku model, which helps us trade-off these shifts, indicates that 10-yr government bond yields are currently trading too low (to the tune of 50-75bp) when mapped against prevailing macro expectations. Taking into account the cumulative impact of the Fed’s security purchases, the degree of mis-valuation of 10-yr bonds is roughly the same across the main regions.
By the way, if you’re looking for a nice illustration of the apparent richness of US bonds (which is to say, yields that are too low), this chart from Citi’s Jeff Amato, comparing yields vs. Citi’s economic surprise index gives a good perspective.