Bond Yields and Yield-Curve Models: A 2008 Perspective

For whatever they are worth, here are some Treasury and corporate bond models, and two flavors of the U.S. yield curve, plus a chart of the U.S. GDP's correlation with U.S. yield curves. Some of the models' projections may be counter-intuitive, but taken together, what these models indicate make sense.

The U.S. 10-yr Bond Yield Model: shows an uptick in yields during the first quarter of 2008, then declines into the 3rd quarter, after which a pullback (rise) in the yield. Risks for further declines in yield may arise towards year-end.




Fed Funds-10yr Yield Curve: shows the yield curve may steepen well into the middle of the year, and flattens thereafter.




2yr-10yr yield curve: shows the yield curve steepening well into the middle of the year.




BAA Corp Yield-10yr Treasury yield: suggests further spread widening into the first quarter of the year, but followed by sharp narrowing of the spread until the third quarter of 2008.




The U.S. GDP and Yield Curve evolution: the correlation chart suggests the U.S. GDP may be biased downwards well into the year-end, but should post strong recovery during the first quarter of 2009.

A How A Global Slowdown Impacts FX Markets

Total OECD LEI (light blue-green line) suggests forthcoming weakness in Industrial Production (red line) and commodity prices; the Baltic Dry Freight Index (black line) as proxy for base metal and raw-material demand. We expect demand in, and prices of, base metals and raw materials to decline further during the rest of the year, as China's growth falters, even as the developed economies show contagion from weak growth in the U.S.



China’s total export value (black line) has peaked, as the Chinese government tries to cool the economy; metal (red line) and raw material prices (blue line) may fall much further . A decline in China's growth comes at an unfortunate time when developed economies are expected to decline as well later in the year.



The U.S. Dollar Broad Index (black line) generally weakens when global growth is strong (Global Industrial Production as proxy, red line), but will broadly strengthen when global growth falters due to a weakness in growth in the United States. The primary reason for this is the tendency of U.S. investors to pull external investments (mostly in emerging market assets) back to the U.S. during times of global financial turmoil (see chart below).



U.S. investors, as a group, control $27.7 trillion worth of funds. These U.S.-based investors have pulled externally invested funds back to the U.S. during financial crises, which tends to support the U.S. currency. We expect the same thing to happen again this time. But the effect tends to be short-lived, and the U.S. Dollar risks will likely remain to the downside until mid-year, and those risks could extend well into year-end.


Some implications of global economic slowdown and forthcoming weakness of commodity demand on EMFX:

• a.Repatriation of US-based funds will tend to support the US Dollar and should weaken low-yielders, and those EM currencies with equity markets whose P/E ratios have converge with G10. These markets will be sold off first.
  
  
• b.There is no “decoupling” – global equity markets will be primarily driven by developments in US equity markets, with EM equity markets with very high P/Es likely to fare relatively worse in the event of a sell-off. Their EM currencies will suffer relatively worse off as well, especially vs the USD
  
  
• c.Stronger USD and lower commodity prices will reinstate the high correlation between EM currencies and their equity markets, as inflation pressures abate

• d.Significant slowdown in China’s demand for raw materials will disproportionately impact negatively on AUD, CAD, NZD, NOK in that order
  
  
• e.Turmoil in EM equities and consequently in EMFX will likely pose much smaller risk for CZK , PLN and SEK to come extent