- Risk assets still well supported
- US growth and inflation going higher
- Euro manufacturing slows temporarily - inflation hits low
- Chinese PMI confirms recovery
Following strong performance in core bond markets this year we believe risk-reward increasingly favours higher yields driven by higher US yields.
First, US growth clearly accelerated in Q2 and our models suggest this will continue into H2. The economic surprise index has also turned higher. Over the past week the improvement was further highlighted by a rise in the US ISM index in May from 54.9 to 55.4 and strong car sales reaching a seven-year high in May at 16.7m vehicles.
Second, US core inflation has turned higher and several Fed members have acknowledged this in recent speeches. Fed’s Charles Plosser said last week that he was encouraged by the rise in inflation as it reinforces the forecast of inflation drifting up towards the Fed’s 2% target. The core PCE deflator rose in April to 1.4% y/y, up from 1.2% in March. The short-term momentum has also clearly picked up as the three-month annualised increase in core PCE inflation is running at 1.8%, not too far from the Fed’s 2% target.
Third, the market pricing of the Fed still looks too low. Although the Fed path in the market has corrected somewhat higher this week, it is still some distance from the Fed’s own median projections, which are quite low to begin with. Our valuation models for US 10-year treasuries also show that fair value is closer to 3% versus the current level of around 2.6%.
Finally, positioning is less extreme now as shorts have been squeezed – probably a factor behind the bond rally. According to our bond positioning index investors have moved from a very big short duration position to an only small short. This removes a further obstacle for higher yields.
As the correlation between US and German bond yields has been very high, we believe a turn in US yields will also mark a bottom for German bond yields. A joker is of course the upcoming stimulus from the ECB, which we expect to be big, but the market often tends to buy on rumour and sell on fact. Especially if the stimulus is seen as the last shot from the central bank – see also ECB research #5: The end of ECB’s easing cycle?, 23 May. At the same time aggressive stimulus should actually work and lift future growth as well as inflation expectations. As the short end of the euro curve is likely to be firmly anchored by the ECB, we expect the euro curve to steepen.
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