The US Treasury market has begun to trade as if the war with Iraq has already been completely won,...
The US Treasury market has begun to trade as if the war with Iraq has already been completely won, with investors no longer rushing to the security of government-backed securities.
Even so, ongoing concerns about the economic outlook are expected to keep yields from climbing much higher, according to Isis global bond fund manager Richard Stevens.
'The market sold off very sharply in mid-March because when the war started, investors thought it would be very short,' he says. 'It corrected about half of that when the allied forces seemed to be struggling. The most recent firming in bond prices suggests while the war may be all but over, the underlying fundamentals of the economy are so bad bonds are going to do all right.'
Stevens adds while there is some expectation of a boost to economic activity from low oil prices and the removal of general uncertainty once the war is over, investors are starting to look beyond this.
'The expectation is that it will only be a very short-term bounce and short-term interest rates will need to be cut more,' he says.
JP Morgan Fleming head of global strategy Chris Tracey agrees the outlook is likely to remain one of low growth and inflation, with US consumption looking exhausted after years of propping up the global economy and no new engine of world growth yet apparent.
Stevens says: 'The budget deficit is ballooning and not just because of the war. There is still disagreement between the houses of Congress on the proposed budget for this year and it is unclear what the eventual package will look like. It is very clear that public finances are on a path of deterioration for the next few years, so there will be a lot more supply of government bonds.'
He adds this is being offset to some extent by a lack of demand for credit from the private sector as corporates continue to reduce debt levels.
Tracey says the likely expense of the war has seen Congress cut president Bush's proposed fiscal stimulus package of $650bn over 10 years back to $350bn, reducing the glut of Treasury issuance expected to weigh on the market.
But tensions over the war with Iraq could weaken the dollar as sentiment sours towards the US, diminishing local currency returns for unhedged foreign investors who remain in the market.
'With an enormous current account deficit, the US is dependent on the rest of the world's savings,' says Tracey. 'If international relationships become even more strained, central banks may be tempted to diversify away from the dollar and into the euro.'
Tracey adds a weaker dollar would also lead to higher bond yields as American assets would need to begin paying a premium to attract capital inflows.
Nonetheless, a lack of attractive alternatives to the dollar means many investors will hold on to the currency regardless of their political standpoint.
'Nobody in their right minds would invest in the yen,' says Tracey. 'This leaves the euro by default, although European economic prospects are pretty dismal, which suggests the dollar is not going to collapse because nothing else looks wildly attractive.'
Economic growth, inflation to stay low.
Lack of credit demand from corporates.
Post-war economic boost.
Improving portfolio diversification
Hanging on the telephone
German recession concerns