Bond Outlook March 24 2010

Two basic, but contradictory, arguments have emerged;

• with the end of QE, governments will increasingly be coming to the bond markets, competing directly with the private sector, and pushing up long-term interest rates
• deleveraging is occurring at such a high rate among households that there are plenty of funds to buy government bonds. In addition, the Chinese and Japanese will continue to be major net purchasers

For many months we have favoured the first argument and recommended short maturities, with the caveat that improved yields are better sought in the private sector rather than lengthening in government credit. Then, last week, we encountered and summarised the analysis of Richard Koo, which is very much supportive of the second argument.

Obviously, to stay short as per our recommendation to date, has meant foregoing higher yields: the 2 to 7 year spread on swap curves is between 100 and 200 bps, dependent upon the currency. In weighing the two contradictory arguments, and in view of the lost opportunity costs, we have concluded that the time has come to lengthen, while preferring corporate to government bonds.