Although daily volatility on the bond markets remains high, yield spikes have abated. Yields will probably trend sideways for the next several months, with large fluctuations on either side unlikely, according to the latest research prepared by UBS.
Volatility was particularly noticeable in the US, where bond yields rose by 6 basis points (bp) on 18 September, only to fall 6 bp days later. This indicates that yields are stuck in a narrow range, a phenomenon that holds true this side of the Atlantic as well.
While 10-year US Treasury yields fell by a good 20 bp in both July and August to reach 4.73% by the end of August, they appear to have bottomed somewhat in September. At least the downward trend of the previous two months was not as severe. US yields appear stuck in a narrow range between 4.7 and 4.9% near-term.
The markets are closely watching US inflation, which has been lower than expected. Taken together with the technical correction and the increasing confirmation that the US real estate market is cooling off as we expected, the US economy is likely to reach its nadir in the next 3 to 6 months. UBS expect 10-year US Treasuries to reach 4.7 and 4.6% in 3 and 6 months respectively. Our economists expect the US economy to receive a renewed boost beginning in the fourth quarter of 2007, which could lead to higher yields of 4.9% on a 12-month horizon.
Ten-year bund yields will probably trend sideways or slightly higher over the next 3 to 6 months around 3.8%. The renewed upturn in US yields and the expected economic recovery should also pull 12-month bund yields up. The yield spread between 10-year US Treasuries and bund yields has persisted at 95 bp despite positive economic momentum in Europe compared to the US. The spread is likely to fall to 90 bp and 80 bp in the next 3 and 6 months respectively, before rising to 90 bp in 12 months as a result of renewed economic momentum in the US.
Confederation bond yields also appear to have levelled off gradually after their downward shift. They continue to follow the US trend and reflect the expectation that the global economy will cool off in 2007. Ten-year Confederation bond yields should therefore stabilize at 2.5% in 6 months.
They will probably then follow the international trend towards slightly higher yields, settling at 2.7%.
UBS now consider a yield of 4.8% on 10-year Treasuries as an attractive point for investing in medium to longer-term US bonds, even if the Fed reduces interest rates in January 2007 as expected. The currency side continues to give preference to European bond markets, but we would hold off on investing in medium to long maturities until the ECB has concluded its cycle of rate hikes, probably in December 2006. In
Switzerland, too, interest rate tightening should likewise be completed in December, when investors could start to consider medium to longer maturities. Central Bank tightening will only come to an end in Sweden and Norway in the next 6 months.
