Meanwhile in the US, the dream of bond bulls comes to an end.
Here’s Nomura’s George Goncalves:
This past week saw further duration shedding across the curve, primarily in intermediates even though the Fed has started its QE2 buying program. What gives? Our core view is that the market was trading offsides and the bulk of the QE2 gains have been erased. This is demonstrated in Figure 1, a medium-term chart of 10Y rates, which illustrates market psychology into & out of the QE2 event.
Recall that double dip recession and deflation fears peaked at the end of the summer, which helped propel investors into bonds and rates to the year’s lows (Figure 1). At one point, some investors were suggesting that the US was on a Japan-like path of deflation and low growth. In the 2 September Rates Radar we listed reasons why the UST market was not becoming the JGB market. During this period of gloom, our economist’s real-time model of GDP was at 0.9% for 3Q, which has since been revised upward to 2.3%.
These concerns were obvious triggers for the Fed reinstituting its balance sheet expansion via a $600bn UST buy program. However, judging by the swift selling and general price action this week, we believe that there must have been outsized longs in the market initiated at the low in yields. The offsides bullish tilt in the market was likely motivated by expectations that QE2 would drive rates even lower in the near-term.
We have argued that this sort of positioning would ultimately end in tears since rates were at extremes relative to fundamentals. In our view, the Fed will try to keep rates lower than where they should be in a recovery, in order to both maintain a liquidity premium in bonds long enough to buy time for the economy & housing to recover, while also forcing investors into other asset classes as a means of reinvigorating animal spirits in the broader economy. We do not believe the Fed wants to completely distort bond markets with ultra low rates—which explains why it was not ready to implement a $1tn-plus, supersized QE.
Instead, the Fed bought time while trying to minimize its footprint in the bond market. This is why it chose a ―right-sized QE2 program toward the lower-end of what many forecasters were expecting (and even then there was some pressure from both domestic and foreign policymakers). We feel that the ongoing disappointment of a smaller QE, coupled with improving economic data (this week’s Philadelphia Fed Index was a positive sign) was behind the bond market sell-off. We believe that the 2010 bullish trend has been disrupted and the new equilibrium still calls for intermediate bonds to gravitate into a higher range.