Don't Fight the Fed

• While we believe that long-term Treasury yields are set to rise as the financial and economic backdrop improves, the Fed's bold move to buy up Treasuries is likely to put a "cap" on yields and we expect Treasuries to range trade in the short term.
• However, given our expectations of a stabilisation in the economy by late Q2 we should continue to receive indications that the worst of the contraction in activity is behind us. This should make the Fed more hesitant to scale up quantitative easing further.
• With the "Bernanke put" in the Treasury market exhausted, any hints from the Fed that the easing cycle is coming to an end could result in a major surge in yields. We therefore recommend investors with a longer investment horizon to use the current setback in yields to open short positions at the longer end of the curve or to move into steepening trades.
• The Fed decision has also fuelled increased speculation of ECB buying government bonds down the road. We still believe that the ECB is miles away from seriously contemplating the buying of government bonds.

Another aggressive move from the Fed

The Federal Open Market Committee (FOMC) took yet another aggressive move at their meeting Wednesday evening, committing to purchase up to USD 300bn in longer-term Treasury securities over the next six months, concentrated in the 2- to 10- year sector of the nominal Treasury curve. This corresponds to between 20-30% of the gross issuance in the coming six months.

In addition, the Fed will expand its MBS purchase programme by USD 750bn to a total of USD 1,250bn and increase its purchase of agency debt by up to USD 100bn to USD 200bn. The Fed also scaled up on the rhetoric on the interest rate stating that the Fed funds rate would be held exceptionally low for an "extended period" compared to "for some time" at the January meeting.

Following the announcement, the 2-10 curve flattened substantially with 10-year Treasury yields dropping by more than 40bp, while the 2-year segment moved 16bp lower. Mortgage yields followed 30-year Treasuries down and 30-year Freddie Mac investor rates dropped to 4.25%.

Stay neutral duration in the short term

From a fundamental view we believe that long-term Treasuries yields are set to increase as the economic backdrop improves and risk appetite returns to markets (see Strategy - US: Bond bear market, but watch the Fed). However, we recommend a cautious stance in the short term, for several reasons.

Firstly, the Fed has sent a strong signal to markets that they prefer to see long-term Treasury yields low as long as credit markets remains severely dysfunctional and the economic outlook remains fragile. The exact limit for yields is unsure but in the short term, we find it difficult to see 10-year yields breaking through the range they have been trading in from February and until the Fed's announcement.

Second, convexity hedging following the large decline in long-term mortgage and Treasury yields could add more downward pressure on yields in the short term.

Third, the Fed has not run out of ammunition and markets are aware that further quantitative easing is possible and could take the form of scaling up Treasury purchases. We think that a confirmation of continuing improvements in credit markets and the economy is likely needed before markets start discounting that the move this week could be the final step in the Fed's quantitative easing.

If we look at the experience from 16 November when the Fed announced its MBS purchase programme for the first time, one could also argue that we have not yet seen the bottom in 10-year Treasury yields. However, this is most likely not a good benchmark for the current situation. The economy was contracting at an accelerating pace at that time and the Fed had not finished its rate cutting cycle. As we see it, the economic and financial market backdrop is in a better shape currently than in late November and December 2008.

On balance we expect yields to range trade short term until markets receive firmer evidence that the economy is improving in line with our expectations.

Approaching a bottom in yields

Given our forecast for a stabilisation of the economy in late Q2 and a gradual recovery in H2, the fundamentals suggest higher 10-year bond yields, even if core inflation continues to fall and the Fed keeps its target rate at zero. This is demonstrated in the simple fair value model below, which indicates a fair value in 10-year bond yields that is 100bp higher than the current level by the end of 2009.

As signs of a stabilisation in the economy become more evident in the coming months and financial conditions improve further, the Fed is likely to signal a more hesitant stance on scaling up its quantitative easing. This, we believe, will pave the way for a rebound in long bond yields. Once markets feel confident that the 'Bernanke put' on longer-term Treasury yields is exhausted, the move upwards in yields could indeed be violent.

Furthermore, the extraordinary supply of government bonds that the market will have to absorb this year is likely to put underlying upward pressure on long bond yields. While the exact impact of the unprecedented financing need is difficult to judge, we believe that it will, nevertheless, continue to be a factor in the Treasury market as we have seen over the last couple of months.

Although we think that yields could range trade in the short term, for investors with a longer investment horizon, we recommend using the current setback in bond yields to enter short positions at the long of the curve or move into steepening trades.

The main events to watch to determine whether we are approaching the end of the Fed's "cap" on longer term yields are the following: the success of the TALF programme, the announcement of details regarding the private-public investment fund or alternative solutions which could spark an increase in risk appetite and a continued improvement in economic indicators such as the ISM index.

Regarding the TALF, the focus is two-fold. It will be vital to see whether it succeeds in reviving consumer credit such as auto loans, but the information on which "other financial assets" the Fed will decide to include as eligible collateral will be as important. Implications for Euroland yields

The Fed decision has also fuelled increased speculation of ECB buying government bonds down the road. We still believe that the ECB is miles away from seriously contemplating the buying of government bonds. ECB is likely to repeat this position in speeches etc. in the coming weeks, but markets may shrug them off as 'the ECB being ECB' and being way behind the curve.

German yields will likely take their cue from US yields and risk appetite short term. So the short term "cap" on US yields will to some extent also apply to German yields. However, German yields have more room to edge higher than US yields in the next couple of weeks should the economic picture and risk appetite point in this direction.

Longer term, German yields will rise and the yield curve steepen on the back of renewed growth optimism and higher US yields. That said, our mediumterm strategic view remains that the US will underperform Euroland as the recovery in the US economy is expected to come sooner than in Euroland.

Danske Bank
http://www.danskebank.com/danskeresearch

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