Bond Yields Extend Fall on Growth Concerns

The bond market flashed disinflationary signals on Tuesday as yields broke below key levels. Markets were otherwise calm as stocks were flat and the carry trade topped FX (AUD led and JPY lagged). The upcoming session features Japans tertiary index and data on Australian wages.

In the Treasury market today the inflation-sensitive 30-year yield fell 5 basis points to 4.22%, breaking below the 200-day moving average. Remember that just last week, the Treasury Dept. sold 30s with a yield of 4.38%. The 10-year and 5-year now also rest just above the 200 dma, with 10s today closing below 3.14% for the first time since December.

The fall in yields shows that the bond market is not concerned about inflation. The thinking is that QE2 was designed to promote inflation. As it ends, it will put downward pressure on prices as the economy slows, even though the Fed will no longer be a buyer.

Todays economic data further promotes this line of thinking. US industrial production was flat in April, missing the +0.5% consensus. The weak headline was due to a 0.4% slide in manufacturing production which was caused by slowing demand for US goods and a drop in automotive production due to the Japanese earthquake. Capacity utilization fell to 76.9% from 77.0%, it was expected to rise to 77.7%. This suggests US industry can absorb a great deal of rising demand before shortages begin to cause inflation.

We are also starting to see downgrades to US growth forecasts with Deutsche Bank pulling down its estimate for Q2 to 3.2% from 3.7% today. For inflation based on high commodity prices to take hold it the US, there needs to be stronger growth. The bond market appears to be signaling that growth will not be strong enough. This means the Fed will not implement an exit strategy, which is negative for USD. If yields continue to fall, especially long term yields, this will be one of the first signals that QE 2.5 or QE3 is being considered.

Remember that slowing growth is also a negative for growth-sensitive currencies, especially the Canadian dollar which is tightly tied to the US. The Australian dollar led today because it is tied more closely to Asia and the RBA minutes suggested interest rate hikes.

Asia-Pacific Preview

The yen slumped on Tuesday on signs that the earthquake is weighing heavily. Bank of Japan Governor Masaaki Shirakawa said the economy is in a very severe state At 2350 GMT, Japan releases the April tertiary industry index, which is a measure of the service sector. It is expected to fall 5.4% due to the earthquake but recent economic data suggests the potential for a large downside miss. Given Shirakawas comments today, pressure may be building on the BOJ to do more to support the economy.

Australias first quarter wage price index will be released at 0130 GMT. Its expected to show wages rising 4.0% y/y after a 3.8% rise in Q42010. Last weeks soft employment report cast doubt on whether the RBA will hike in June but a reading above 4.1% would probably tilt the balance in favour of a hike. A reading at 3.8% or lower may push expectations toward an August hike, rather than June or July.

By AB - AshafLaidi.com