Sovereign bonds
Comment of the Day

August 20 2012

Commentary by Eoin Treacy

Sovereign bonds

Eoin Treacy's view There is a quite a debate going on at present about the prospects for sovereign bonds. Those who consider an inflationary outcome inevitable quote energy, food, insurance and education prices, and the continued uptrend in money supply to support their arguments. Those who see a deflationary outcome as inevitable quote unemployment, wages compression, spare industrial capacity and deteriorating velocity of money to support their arguments.

Rather than indulge in a philosophical argument, let us instead examine investor behaviour. Governments are rapidly increasing the supply of sovereign bonds as they seek to avail of the lowest cost of capital in living memory; at least for some countries. Corporations are seizing the opportunity to optimise their balance sheets by issuing long-dated bonds at favourable yields and buying back their shares while valuations are reasonable. This policy is made all the more compelling where corporate bonds yield less than equities. Investors have become so disillusioned with the stock market that they are willing to accept negative real yields. In a situation where investors have been falling over one another in their haste to enter the bond markets, contrarians begin to ask how sustainable this all is.

Since the majority of institutional investors in bonds are total return oriented it is logical to approach the market from that perspective. When viewed over a number of decades, it is easy to see why investors have placed such faith in Treasuries. The Merrill Lynch 10yr+ Total Return Index exhibits one of the most consistent chart patterns of any instrument. It has found support in the region of the 200-day MA on successive occasions over the last 30 years. Since this is such an obvious consistency characteristic, when it finally breaks below the MA, encounters resistance in the region of the trend mean on a subsequent rally and extends the downtrend, it will represent a clear signal that a secular trend change has occurred.

The Index lost momentum over the last year and has been pulling back over the last month having hit a new peak in late July. Demand will need to return in the region of 1900 if the benefit of the doubt is to be given to the upside. As Treasuries futures prices test the upper side of the underlying trading range, this region represents an important area where demand could potentially return to dominance. Japanese, German, UK, Switzerland, Australian and Canadian yields are also reverting towards their respective means.

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