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(photo credit: Bloomberg)
The Israeli bond Investors are at a crossroad regarding their strategic debt allocation. The issue that makes their decision even more complicated is how to play the short term strategy given that the medium term outlook is negative.
There are many economic parameters that support a rise in yields over the medium term - a trend that is estimated to start in the first quarter next year and toward the year of 2012.
Short Term: in the short term, the dynamic of the conventional government bond market (non-linked to inflation) is affected by different forces than the dynamic of the midterm.
In the short term, the market will be affected especially by the trends of the US treasuries' market, stock market, investors' sentiment, inflation expectations (which are derived from the breakeven rates (inflation linked bonds), and estimations about the beginning of the monetary tightening campaign of the Bank of Israel.
According to the Makam market (Zero Coupon bond) the interest rate is estimated to rise in December by 0.25% to 0.75%. However, we believe that a rate hike will be a politically incorrect step and impossible due to the weak economic environment. We estimate that the first rate increase will occur in the first quarter of 2010.
The market still doesn't price a situation of a tightening monetary policy (interest rate increases). Our mathematical models suggest that in the near term, the yields along the curve will go down. We estimate that the Memshaltit Shiklit due to February 2019 will go below 5% in the near term.
However, since the potential profit from investing in the long duration non-linked government bonds is low while the risk is high, we do not recommend a high exposure in the long part of the curve.
Geopolitics: The bond market probably has discounted already the geopolitical issues (Iran, Palestinian Authority, Hezbollah). It seems that the bond investors aren't getting excited (neither negatively, and of course nor positively) by the noises arising from the Iranian front. However, bond investors should be aware of negative short run implications in case of military actions.
Regarding the medium term (6 month to 2 years), we estimate that the yields along the conventional curve will go up, and will follow the trend of the US treasuries market. We also estimate a moderate flattening of the yields curve.
The primary factors that will affect the yields upwardly (beside the trend of the US treasuries) are:
One, upward trend in the medium term breakeven rates (inflation expectations of 2 years to 5 years).
Two, tightening monetary policy - we expect first increase in the first quarter in 2010. We expect an interest rate of 2.5% in the end of 2010.
Three, increase in investors' appetite for higher yielding assets - stocks, corporate bonds etc. this will be a result of economic stabilization.
The writer is Chief Analyst and Strategist at Alumot-Sprint Investment House