Investors are turning increasingly bullish on the near term outlook for US Treasuries, saying slowing economic growth and still benign inflation may help the debt markets bloom this spring. US government bonds were boosted on Friday after data showed underlying US inflation pressures remained subdued and consumers were more restrained in their inflation outlook.
-- Rates seen likely to rally on slowing growth
-- End of QE could spark short squeeze, send rates lower
Gains are seen likely to continue as investors adjust to recent data showing the economy growing at a slower pace, which may make the Federal Reserve slower to raise interest rates than bonds are currently pricing for. "We now believe it's time to start buying bonds again ahead of the debt ceiling and end of QE2 discussions," said George Goncalves, head of rates strategy at Nomura Securities International in New York.
Benchmark 10-year note yields could drop another 25 basis points as investors adjust to declining economic growth expectations, he said. A report showing that industrial capacity use jumped in March to its highest level since August 2008 offered encouraging signs for the economy on Friday though it comes as economists have been cutting growth forecasts.
Ten-year yields were down 9 basis points on Friday to 3.41 percent. Treasury trading volumes on Friday were around 92 percent of their average, according to ICAP. "We believe...the end of QE2 would simply push buyers out of risk assets and back into Treasuries," said Goncalves.
Some investors including PIMCO's Bill Gross have warned the end of the Fed's $600 billion bond purchase program in June could spark a massive selloff of bonds as it may be difficult to find enough other buyers to replace the Fed. Others say the removal of the stimulus will, contrarily, help debt markets.
Bond yields have risen since the program was implemented in November, and when it ends the economy may again slow, sending rates back lower. Stimulus "when it's taken off, has led to a weaker economy, deflationary forces blowing in the economy and rates falling," Jeffrey Gundlach, CEO of $9.5 billion DoubleLine Capital, said on a conference call on Tuesday.
"I think that's going to happen again," he said. Credit Suisse's Carl Lantz predicts the Fed's exit from the market could provoke a technically-led squeeze on the debt that sends rates lower. That is because dealers and investors are significantly short the market, and as such vulnerable to an unanticipated rally.
"Our base case is that rates will tend to rally around the end of the program as disappointed shorts are "squeezed" into the market," Lantz said. Dealers are now holding the largest net short Treasury position since 2008, at nearly $50 billion, and fund managers are also substantially short the debt relative to their benchmarks.
Morgan Stanley also sees risks that second quarter data could disappoint, leading investors to re-evaluate their rate outlook. "We believe the second quarter is the most important quarter of the year because it needs to show a sharp rebound in growth in order to keep us on track for 2011 consensus growth estimates," said Jim Caron, head of global interest rate strategy.