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Yield Economics – Markets – Strategy US Treasury yields are likely to rise sharply US: Bearish Treasuries We believe Treasury yields will rise more than 100bps during 2H08. With improving economic growth, inflationary pressures that may not be temporary, and increasing bond supply, we are bearish on the US bond market, which we think will have to discount substantial Fed tightening for 2009. Much argues for a substantial sell-off in bonds. If the US economy picks up and credit conditions improve in 2H08 and 2009, the Fed will have to remove the policy accommodation that is currently in place with Fed Funds at 2% (see the US economics section for details). We are confident that growth should improve, thanks to: a) continued noncyclical core consumption growth b) relatively strong foreign demand c) fiscal injections equivalent to 1.75% of GDP now coming on stream d) a housing sector that will subtract progressively less from growth in the coming quarters e) lower interest rates Moreover, there is the risk of an inflation psychology developing among consumers, which suggests that even if the economy only grinds forward in the coming quarters, the Fed might raise rates to prevent inflation from becoming an entrenched phenomenon embedded in the economy. Specifically, as growth improves to 2.5-2.75% (saar) in 2H08 and maintains at this pace in 2009, we expect the Fed to hike Fed Funds by 50bps to 2.5% in 4Q08 and by 175bps to 4.25% in 2009. Fed tightening of this magnitude is not priced into the yield curve, which means the front end will have to steepen if the market comes around to the view that policy rates have to rise considerably. Judging from recent history, 2Y yields could rise to 200bps above Fed Funds (i.e. to 4%) in 2H08, before the Fed even starts to hike interest rates (Chart 1). Chart 1: UST 2Y Yield - Fed Funds %pa bps Chart 2: UST 10Y Yield - Fed Funds %pa bps 7 300 7 500 6 200 6 400 5 4 3 2 100 0 -100 5 4 3 2 300 200 100 0 1 Fed Funds Target Rate UST 2Y - Fed Funds (RHS) 0 Mar-91 Mar-94 Mar-97 Mar-00 Mar-03 Mar-06 -200 -300 1 Fed Funds Target Rate UST 10Y - Fed Funds (RHS) 0 Mar-91 Mar-94 Mar-97 Mar-00 Mar-03 Mar-06 -100 -200 Using the current regression relationship between 2Y and 10Y yields as a rough guide, a rise in the 2Y yield to 200bps above Fed Funds (i.e. 4%) would put 10Y yields at least 300bps above Fed Funds (i.e. to 5%), implying a flattening of the 44
Economics – Markets – Strategy Yield Chart 3: 2Y UST Yield - FFR vs 10Y UST Yield - FFR Chart 4: 10Y UST Yield vs 2Y UST Yield - FFR Y = 10Y UST Yield - Fed Funds (bps) 350 y = 0.666x + 157.56 300 250 Forecast 200 from 30 Apr 08 150 100 last 60 trading days 50 0 -200 -100 0 100 200 300 X = 2Y UST Yield - Fed Funds (bps) 10Y UST Yield (%pa) 5.50 5.00 4.50 A Forecast Current 4.00 B C A: Jun07 to Dec07 3.50 B: Dec07 to Mar08 C: Mar08 to Currnet 3.00 -200 -150 -100 -50 0 50 100 150 200 250 2Y UST Yield - Fed Funds (bps) 2Y/10Y curve to 100bps from 120bps currently (Charts 2 & 3). While the current regression relationship based on the last 60 trading days is likely biased towards low 10Y yields (i.e. the regression line is too flat), a yield level of 5% for the 10Y yield also looks reasonable on a scatter plot based on the last 250 trading day (Chart 4). Singapore: Upward pressures are building on SGD rates With the Fed rate cut cycle having come to an end, upward pressures are building on SGD rates. A rise in US Treasury yields in 2H08 on the back of more aggressive Fed rate hike expectations is expected put SGS yields under upward pressure. Higher SGS yields are, hence, likely by year end, even if SGD money market rates remain low until the Fed starts to lift its target for Fed Funds in 4Q08. That said, SGS yields are unlikely to rise as fast as their US counterparts, resulting in wider spreads between SGS and UST rates (Chart 5). In response to the expected flattening in the 2Y/10Y US Treasury curve, the 2Y/ 10Y SGS curve should flatten too. Given our expectation that USD/SGD will rise in the months ahead and reach 1.40 by year-end, there is, in fact, the possibility that the 2Y/10Y SGS curve flattens relative to the 2Y/10Y UST curve. This is because trends in the currency markets could entail higher SGD money market rates. US Treasury yields are likely to lead SGS yields higher Chart 5: UST/SGS 2Y & 10Y vs Libor-SOR 12M bps 300 250 200 150 100 50 UST/SGS 2Y Spread UST/SGS 10Y Spread Libor 12M - SOR 12M Spread 0 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Chart 6: SGS 2/10 Spread vs UST 2/10 Spread bps 300 250 200 150 100 50 0 -50 SGS 2/10 Spread UST 2/10 Spread -100 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 45
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