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US rates
Duration preference: neutral

UBS View
US 10-year (29 June): 1.6% (last month: 1.7%)
US 10-year (6-month forecast): 1.8%

• US 10-year yields have recovered slightly from their June 1st 2012 lows after a reduction of political risks in the Eurozone. However, Treasury yields remain near historical lows due to the extension of Operation Twist (OT) coupled with recent setbacks of domestic economic data.
• We expect a marginal rise in yields since the US economy remains on a moderate cyclical growth path with the housing market having bottomed out. Additionally the diminished near-term risk of a Greek exit from the Eurozone following elections supports a gradual rise in Treasury yields.
• However, over a six-month horizon, the extension of Operation Twist (OT) until the end of 2012 by the Federal Reserve (Fed) will limit the upside potential in yields. As of late, the probability of even more stimulus in the form of quantitative easing from the Fed has risen substantially and markets have pushed out the first rate hike expectation into 2015. Additionally, structural obstacles from the pending US fiscal consolidation will also limit the upside potential for yields. Further, the US economy seems more vulnerable to possible spillover effects of increased political uncertainties in the Eurozone.

Positive scenario for US bonds
US 10-year (6-month range): 1.5–1.7%
• The European debt crisis further re-escalates. The resulting contagion would intensify the current flight to quality, with Italian and Spanish spreads above 550 basis points to the Bund (our base case).
• With the increased likelihood of further quantitative easing, the risk is that yields would stay low or fall lower.

Negative scenario for US bonds
US 10-year (6-month range): 2.3–2.9%
• If the EU leaders indicate serious commitment towards more fiscal integration, and US growth proves more sustainable with a rapidly improving labor market, then yields could rise.
• Recently, market expectations regarding future rate hikes by the Fed have pushed out a first rate hike into 2Q 2015. Any re-pricing into 2014 or 2013 will result in higher yields.
Note: Scenarios refer to global economic scenarios (see slide 7)

What we're watching Why it matters
Fed policy The Fed's assessment of the labour market determines it's stance on quantitative easing and is key for yields. Key dates: 31 July, Federal Open Market Committee meeting
Labor market Key focus of the Fed, judged in part based on estimates of the non-accelerating inflation rate of employment. Key date: 6 July, US non-farm payrolls
Inflation expectations Current yields reflect low real interest rates, but rather normal inflation expectations. If inflation expectations decline, the risk of a deflationary spiral would exist, leading to more downside risk for long maturity yields.
US presidential election The US presidential election will guide fiscal spending for the coming years.

Recommendations
Tactical (6 months)
• Declining growth momentum, extension of Operation Twist by the Fed and a rising likelihood of a rate cut by the ECB, are likely to keep yields on extraordinary low levels, for the time being. Thus we suggest a neutral duration position tactically.

Strategic (1 to 2 years)
• Yields have significant upside potential over the next couple of years given the current extraordinarily low levels – of real interest rates in particular. Thus clients with a longer time horizon should focus on bonds with short and medium maturities

USD 10-year yields and forecasts
[Chart displaying yields from Jun-09 to Jun-13]
Source: Bloomberg, UBS CIO, as of June 18th 2012
Note: Past performance is not an indication of future returns.

UBS
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For further information please contact CIO's asset class specialist Daniela Steinbrink Mattei, daniela.steinbrinkmattei@ubs.com
Please see important disclaimer and disclosures at the end of the document.
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