Bond Outlook July 20th

Whither inflation and whither 10-year yields in USD? To say that opinion is divided is an understatement. It suffices to read the MSI Weekly to see Roach arguing that low inflation is a global phenomenon, which prevents its return to the USA, while Berner argues that phenomena like a stronger dollar, cheaper imported apparel and moderation in commodity prices are temporary. We lean towards the latter's view because the low unemployment in the USA and high capacity utilisation (now 80%) are returning pricing power to suppliers. Yet Roach's argument about convergence makes sense; a massive take off in inflation looks highly improbable. There is likely to be just enough inflationary pressure to comfort the FED in its policy of lifting the overnight rate steadily till 4¼ to 4½%, with the long end of the yield curve following at a slower pace. We still think a barbell is appropriate in USD, but with a gradual reduction of the 10-year component.

In the other major currencies, staying long is perfectly appropriate. The Battle for Europe has necessarily gone quiet as the holiday season begins, but we take encouragement from the Merkel/Sarkozy meeting in Paris.