Despite the summer doldrums, the main feature of global bond markets continues to be revisions to ma...
Despite the summer doldrums, the main feature of global bond markets continues to be revisions to market expectations of interest rate rises in the US and the UK.
Following the release of a number of weaker-than-expected economic indicators the market is now discounting a peak as investors believe that we are now close to the end of the current interest rate cycle. In anticipation of this, 10-year US yields have fallen 0.8% since mid-May and short-dated gilt yields have fallen below 6.0%. The fall in longer dated yields has been exacerbated by technical factors including the reduced supply of government paper and the minimum funding requirement (MFR) review.
At the same time, heavy corporate bond issuance and general deterioration of credit ratings has had a negative impact on the yield differential between government and corporate bonds. As these factors are likely to remain, corporate bonds are also likely to continue to underperform.
In the US, the optimism about the prospect of a soft landing may be overdone, leading to the risk of a bond correction in the short term. However, historically, when US GDP growth has slowed, nominal and real rates have tended to contract and this is good news for the bond market, especially for US index-linked bonds (Tips) yielding 4.0% real.
In Europe, stronger growth, rising inflation and higher interest rates will put long dated yields under pressure. At the same time, the strong fundamentals will benefit the euro against sterling and the US dollar.
In the longer term, the Bank of England's pro-active stance on interest rates provides a strong support for gilts, especially short and medium dated gilts. The persistence of a large public sector surplus and the rise in corporate debt issuance has resulted in technical distortions between the Government and corporate bond markets. This is likely to persist and we remain cautious on the prospects for corporate bonds relative to gilts.
In Japan the JGB market seems threatened by a pick up in growth, higher interest rates and a deterioration of credit quality. With public sector debt close to 125% of GDP and a 10% current budget deficit, JGB yields should suffer from the larger risk premium. Under these conditions therefore, why buy Japanese bonds offering a yield 4% lower than US Treasuries, 3.4% lower than German bonds and 3.5% lower than gilts?
JGB's are mainly owned by Japanese investors and from a domestic view, Japanese bonds are still attractive. Not only do JGB's offer 1.5% extra yield compared to cash but they also offer good real value. With inflation still in negative territory, the real yield on JGBs is currently higher than the real yield on UK index-linked bonds.
The rate hike was a psychological move aimed at indicating that the crisis is over. With the economic recovery under way, the yen could well outshine the dollar, sterling and also the euro.
Michel Gonnard is head of fixed income at Cazenove Fund Management
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