NEW YORK - With the significant yield curve flattening witnessed recently, analysts at Deutsche Bank Securities warned that fixed-income market participants are too closely focused on the risks resulting from higher interest rates and not enough on the imminence and potential negative impact of a market rally.

At a semi-annual press briefing held last week, Deutsche Bank's head of U.S. rates research Mustafa Chowdhury said that currently there are more factors - which are also more technical - that are pulling rates down than those pushing them to rise.

Chowdhury enumerated the factors that could lead to and would be adversely impacted by a market rally, contrasting them with a sell-off scenario that most market participants are currently positioning for.

He cited the current account deficit that is expected to remain fairly robust even as the dollar goes down. This would mean that foreign central banks would be buying more U.S. Treasurys to build up their returns, pushing rates downward. Chowdhury also noted that a lower rate scenario would be especially detrimental to pension funds whose liabilities usually exceed the value of their assets. Chowdhury said that the difference between the assets and liabilities would increase in a market rally.

Chowdhury also talked about the mortgage market, noting that the concentration of mortgages outstanding is currently in the lower coupons. He said that if the 10-year Treasury yield falls to 3.5%, refinancings will kick in once again and duration buying could ensue. By contrast, in a rising rate scenario, there will be no reason to sell fairly low coupons. In other words, the duration of the market does not change as much and convexity risks are not as pronounced in a sell-off.

He also said that duration money managers across the world and in the U.S. are currently short to their respective Indices, meaning that a market rally might "catch them by surprise, which could be a painful scenario," according to Chowdhury. He also noted that the supply outlook in the different fixed-income sectors such as Treasurys, Agencies and mortgage-backeds is currently low. However, there remains robust demand coming from foreign institutions. This supply and demand imbalance in the different markets could trigger a rally.

Chowdhury said that while the market is closely monitoring core consumer inflation - which indicates the consumer's lending and borrowing rate - in anticipation of a higher interest rate scenario, and are overcompensating for a potential sell-off, it would also be good for investors to prepare for a market rally given the number of factors that could bring about this event.

Copyright 2005 Thomson Media Inc. All Rights Reserved.

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