How close is the end of US Government bond yields rally?

The trend of the last weeks

US 10 year Government bond yields jumped from 2% on May 22^nd – when Fed President Mr. Bernanke suggested that the Fed might cut back on bond purchases some time in “the next few meetings” and the minutes of April 30^th/May 1^st monetary policy meeting indicated that “a number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting – to 2.61% on Monday 24^th. From the lowest level touched on May 2^nd at 1.63% yields increased by 98bp.

The upward trend of 10 year yields further strengthened following the Bernanke’s press conference on June 19th, when he confirmed that that the central bank could reduce its purchases this year and halt them around mid-2014. The acceleration of the yields increase fuelled concerns that rising government bond yields could have a negative impact on equity markets. However, S&P500 was so far resilient, falling by a mere 3.4% from the historical high at 1655 set on May 22. On Wednesday 26th 10 year yields corrected to 2.52% as final Q1 GDP data disappointed investors: indeed it was revised down from 2.4% to 1.8% annualized, mainly due to weaker consumer spending growth.

Fed’s reaction

The strong increase of Government bond yields alarmed Fed’s members. For example, Minneapolis Fed President Narayana Kocherlakota said in an interview with CNBC on Wednesday 26th that the bond-market reaction to last week's Federal Reserve decision was "outsized". He also highlighted that the Fed needs to defend its 2% inflation target both from above and below.

Limited upside potential

Our base scenario is that from current level government bond yields have limited upside potential. In our view, 10 year government yields will hardly exceed the 2.75% target for year-end set by Deutsche Bank chief economist Joseph LaVorgna in a recent note. Indeed we believe that the economic outlook does not support a further increase of government yields.

First, because US economy lacks a strong engine of growth in the next few quarters:

1)     Consumer spending is likely to continue expanding at moderate pace (1.5/2.0% annualized) as jobs creation remain weak;

2)     Government spending contribute to economic growth will soften for the spending cut become effective since March 1^st; 

3)     Investments are likely to be negatively impacted by the tightening of fiscal policy;

4)     Exports will suffer due to weakening of economic activity in emerging market and recession in the Euro zone.

Second, because inflationary pressures are well contained and are not expected to pick up in the foreseeable future.

The case for being bullish

In our view, the potential for a decline of Government bond yields in the months ahead is higher than the potential for a further increase. In particular should economic activity being weaker than Fed projections for a 2.4/2.5% GDP growth in 2013 and 3.2/3.3% in 2014.

A similar view is shared by Jeffrey Gundlach, head of DoubleLine Capital LP. He said on Tuesday 25^th that “the selloff in the bond market is likely to end in the next few weeks and that now is the time to consider buying riskier debt”. Gundlach characterized the selloff in the bond market as a "liquidation cycle" that will end within weeks, once the benchmark 10-year Treasury hits a high of 2.75%.