>INTEREST RATE STRATEGY (DBS)

US: Thinking Ahead

• 10Y Treasury yields have risen 150bps since the beginning of the year, begging the question as to whether 3-4% is the 2H09 trading range or yields will fall back into the 2-3% range that prevailed from Jan09 to Apr09

• The case for higher yields has strengthened because a recovery story has gained traction. But for yields to remain above 3%, the market has to remain focused on inflation and not deflation. The inflation outlook remains the primary driver of Treasury yields; the growth outlook and supply outlook remain secondary

• Contrary to the common view that supply has been pushing yields up at the long end, we think that the market has merely repriced itself in 2Q09 to reflect better macro data and lower risk of deflation

• With recovery now being priced in, what is the most reasonable yield curve scenario ahead?

• A simple regression model suggests that 3-4% is a reasonable trading range for 10Y yields in 2H09.

• 10Y yields above 3% are consistent with expectations for positive GDP growth, core PCE inflation staying above 1% and upward pressure on 3M Libor in 2010

• As there are still question marks as to how strong deflationary pressures are and how strong recovery will be, yields are unlikely to rise above 4% in 2H09

• As the inflation outlook remains key, and inflation should remain low in the near-term, 10Y yields are more likely to fall into the 2-3% range than rise into the 4-5% range in 2H09

• Until the Fed starts to hike rates, the 2Y/10Y curve is likely to continue to exhibit a flattening bias into rallies and a steepening bias into sell-offs

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