Government Bonds: Not a Long-Term Buying Opportunity

Government bond yields were expected to rise over the spring as the QE2 program of the Fed came close to an end in June and inflationary pressures remained elevated amid high energy prices. However in the last few weeks U.S. Government bond yields fell, with the 10 year yield declining below the 3% ceiling and below its 40 week moving average for the first time since December 2010. The German 10 year yield also strongly fell despite economic data for the biggest Euro zone country remaining positive: from 3.4% in April to 3% over the last week.

The main reasons behind the decline in Government bond yields were:

1. Weak economic data released all around the world and especially in the USA. As an example the ISM manufacturing index fell in May from 60.4 to 53.5 – the lowest since September ’09 – and non-farm payrolls rose by a lower than expected 54k in May (the unemployment rate rose from 8.9% to 9.1%);
2. Expectations that the Fed may implement a QE3 program in the next few months;
3. The uncertainties on the Euro zone peripheral countries outlook, with Greece needing a second bailout plan just 1 year after the first plan was implemented.

In the short term we expect the downward trend of Government bond yields may continue both in the Euro zone and in the USA. Indeed economic data due for release over the next weeks are likely to confirm a softening of the economic rate of growth in the short term amid the consequences of the earthquake that struck Japan on March 2011, which disrupted economic activity especially in the auto sector. Moreover some analysts highlighted that economic data may be negatively influenced in the short term by problems in the seasonal adjustments process.

However, should the current softening of economic growth prove temporary thanks to a rebound in the Japanese economy in the next few months, as our base scenario, we think Government bond yields may resume an upward trend as inflationary pressures should remain elevated in the short term, unless there's a strong decline in oil prices.

Moreover we see the chances that the Fed will implement a QE3 program in the short term as very low. Only in the case of a new recession may the Fed decide on a new expansionary monetary policy. However we believe that the possibilities that the U.S. economy will enter in recession in the next year are low, in line with the indications coming from the NY Fed probit model (pdf) that see the chances of a recession in the next 12 months as 0 - (click to enlarge).

Finally we see little value in the long term government bond both in the USA and in the Euro zone. Indeed according to the rule of thumb that the fair value of the 10 year yield should be equal to nominal GDP growth, we estimate that a fair value for yield should be at least at 4% in both the countries.

For these reasons we do not see the long term government bond yields as a medium term Buying opportunity.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.