Global Markets: The Three Little Bears - Dollar Bear, Bond Bear and the Ratings Bear

HIGHLIGHTS

• The stand out market trends of the past month or so have been the massive sell off in long bond yields, the substantial depreciation of the USD and the surprising power of credit rating agencies with some of their recent pronouncements on sovereign credit rating risks.
• With further job losses to come, inflation more likely than not set to fall and any pressure for the Fed to flag the start of a monetary policy tighten cycle well into the future, U.S. 10 year bonds appear set for a correction towards 3.25%
• TD now forecasts that the Canadian dollar will reach parity with the U.S. by the end of 2009 based on a variety of factors discussed in this report.
• The publication also includes quarterly interest rate and exchange rate forecasts for the U.S., Canada, Australia, and New Zealand, and also offers additional exchange rate forecasts for the Japanese yen, the euro, the U.K. pound, and the Swiss franc.

The stand out market trends of the past month or so have been the massive sell off in long bond yields, the substantial depreciation of the USD and the surprising power of credit rating agencies with some of their recent pronouncements on sovereign credit rating risks.

The first two events - the sharp jump in long bond yields and the USD decline - are probably related. The supply of U.S. government bonds is hitting the market at an unprecedented rate, while at the same time, there is a chunky maturity profile of outstanding bonds coming through plus there is an issue with just about every other country in the world ramping up its bond issuance to cover large and increasing budget deficits. The story unfolding is that yields may well have to rise to attract a given amount of global capital. We have tended to downplay this link between rising supply and rising yields simply because the historical experience in fact shows the opposite trend. That is, high bond issuance results from a recession, which results in low inflation and risk aversion, which in all, is bond supportive. Low bond issuance, on the other hand, is usually associated with strong economic growth, upside inflation pressures, and a strong appetite for risk, all of which are bond bearish.

General trends in bond yields, it seems, are much more likely to be influenced by headline inflation than bond supply. This makes the sharp 150 basis point and more back up in U.S. 10 year yields over the past couple of months somewhat hard to fathom with inflation still flat to lower in annual terms and further falls in inflation likely to emerge in the next few months.

We are still not thoroughly convinced that bond supply will have a lasting influence on bond yields. We would prefer to look at likely trends in monetary policy settings (on hold or lower are still dominant themes around the world) and inflation as the greatest lasting influence on bond yields. While inflation is indeed currently very low, there may be some budding inflation pressures being hinted at in both the CPI and PCE deflators. We note that in the first four months of 2009, the core readings in both these key inflation measures have increased at an annualised pace around 2 ¾ % - not fatally high after the inflation fears of 2008, but a trend that is at least a little disconcerting given the amount of policy stimulus flooding around the world. Our bullish bond call and suggestion that the yield curve will flatten significantly, is based on these inflation trends reversing as the recession rolls on.

Where the budget deficit issue may have a more lasting effect is in the USD. With the U.S. heavily reliant on foreigners to fund its budget (more than 50% of all Treasurys are held offshore), the USD may have to cheapen to attract sufficient foreign interest, especially when virtually all governments in the world are escalating their bond issuance to fund their deteriorating fiscal positions.

What's more, with Standard & Poors flagging a negative watch for the U.K. in the light of its fragile public finances, the market superimposed that logic to the U.S., observed an even more parlous position in the U.S. and now is nervous about the ability of the U.S. to contain debt over the medium term. This view looks valid, a point that is likely to weigh on the USD over the medium term, even though rating agencies said that there is no threat of a downgrade in the U.S.

Allowing for all of that, the economic fundamentals of the globe remain extremely bad. The run of Q4 2008 and Q1 2009 GDP results in all major and most minor economies show shrinkages in output. Further, house prices just about everywhere are flat at best, or are still falling sharply at worst while unemployment is rising at a rapid pace. The so-called green shoots of recovery that are being touted by some as a sign of a meaningful recovery in the economy are invariably indicators declining at a less rapid pace which admittedly is always a first thing to turn before a fully fledged recovery, but nonetheless do not inspire unambiguous optimism about the sustainability of the recovery in the near term.

The 'greens shoots', it should also be noted, may simply reflect simple forecasting errors from the consensus. At the depths of the low, there may well have been a bias (subliminal probably), to tilt the forecasts to the downside. This may then have seen a few 'less bad' results that sparked some optimism, risk taking and bond bearish trends. As an aside, who frankly can forecast things like consumer sentiment, the ISM or a raft of other indicators in a credible manner. As a result, surprises in these data releases, which may be seen as green shoots, have little credibility, even though markets may have knee jerk reactions to them.

Suffice to say, global GDP is shrinking, wealth is declining and household incomes are under downward pressure. This is not the material that inspires confidence about a sustained recovery, nor does it validate the back up in long bond yields. It does give one confidence about forecasting low inflation which, as the chart above shows, is usually a key driver of lower 10 year yields.

With many comparisons being made between the current situation in the U.S. and the 1990s in Japan, it is noteworthy that even during what has to be one of the most phenomenal bond rallies ever seen (10 year JGB yields fell from 5% to 0.75%), there were a couple of episodes, which lasted up to 6 to 9 months, where 10 year JGB yields jumped around 150bps. Both were associated with positive expectations for the economy but both were quickly reversed.

With further job losses to come, inflation more likely than not set to fall and any pressure for the Fed to flag the start of a monetary policy tighten cycle well into the future, U.S. 10 year bonds appear set for a correction towards 3.25%, possibly less. Longer end yields are also likely to be dragged lower, and as a result, the yield curve is poised for a major flattening.