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US rates
Duration preference: neutral

UBS view
US 10-year (24 Oct): 1.8% (last month: 1.8%)
US 10-year (6-month forecast): 2.0%

• US 10-year yields traded largely sideways within a narrow range. Improving domestic economic and sentiment data was balanced by concerns of the elections/fiscal cliff weighing on the US economy. However, both the ECB and the Fed have provided substantial and credible backstops that significantly reduce tail risks. This reduces the flight to quality and the risk discount placed on Treasuries in the event of a re-escalation of the European debt crisis. This represents a clear floor with little chance of retesting the historical lows of July (~1.4%). In addition, the Fed's willingness to fall behind the curve in support of the domestic labor market will increase inflation expectations over the medium term. This implies steeper yield curves.
• In addition, the credible and conditional central bank backstops have already improved sentiment and should help to kick-start growth if politicians provide the necessary tailwinds. Yields will then return to their slightly higher, previously stable ranges over a six-month horizon (1.8%-2.1%).
• At the same time, US yields should be capped, as the US economy continues to be vulnerable to spillover effects from the Eurozone. Structurally weak growth which will be dampened by the upcoming US fiscal consolidation, will add to volatility and limit the increase in yields.

Recommendations
Tactical (6 months)
• Weak global growth momentum, ongoing bond market support from central banks and the lingering euro crisis are likely to keep yields at extraordinarily low levels for some time. Tactically, we suggest a neutral duration position.

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

Positive scenario for US bonds
US 10-year (6-month range): 1.4–1.6%
• US fiscal deleveraging beyond our expectations weighs on the cyclical recovery and is a drag on yields.
• A re-escalation of the European debt crisis burdens yields. Implementation risks in the ECB framework remain, given that Italy and Spain have not yet made the necessary application, which will result in the peripheral spread widening. At the same time, Greece is likely to announce a second debt restructuring and leave the Eurozone next year.
• The labor market fails to recover, increasing the likelihood of even more MBS purchases or alternative measures, and yields stay low or fall further.

Negative scenario for US bonds
US 10-year (6-month range): 2.1–2.5%
• If the ECB buying of short-dated Spanish and Italian sovereign bonds increases risk appetite, it would reduce the flight to quality more substantially and this represents an upside risk to our forecasts.
• If EU leaders make progress toward increased fiscal integration, and US growth recovers with a rapidly improving labor market, then yields could rise more significantly.
Note: Scenarios refer to global economic scenarios (see slide 7)

USD 10-year yields and forecasts
[Graph depicting yields from Oct-09 to Oct-13]
5%
4%
3%
2%
1%
0%
Oct-09 Oct-10 Oct-11 Oct-12 Oct-13
forecasts — US 10Y
Source: Bloomberg, UBS, as of October 15, 2012
Note: Past performance is not an indication of future returns.

What we're watching
Fed policy
Inflation expectations
US presidential election/Fiscal cliff & debt ceiling

Why it matters
The Fed's assessment of the labor market determines its stance on quantitative easing and is key for yields. Key dates: Nov 2, NFP; Dec 11 Fed FOMC meeting
Current yields do not reflect low real-interest rates, but rather normal inflation expectations. Inflation expectations increased on the back of the latest Fed action, leading to more upside risk for long maturity yields.
The US presidential election will guide fiscal spending for the coming years.

UBS
24
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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