During the last few months of 2000, slowing economic growth hit the US corporate bond market, with...
During the last few months of 2000, slowing economic growth hit the US corporate bond market, with the yield differential between corporate and government bonds widening. This movement has been partly reversed during 2001 with interest rates cut aggressively.
In the UK, economic growth has remained robust in the face of the slowing global economy. This firmer trend in the economy meant that the Bank of England's Monetary Policy Committee was less aggressive than the US Federal Reserve in cutting interest rates.
More recently, however, falling equity markets and the foot and mouth crisis have resulted in the MPC cutting interest rates to their current level of 5.5%.
Towards the end of 2000, above-target inflation, coupled with the weak euro, prompted the European Central Bank to increase interest rates. However, at the beginning of the year, eurozone inflation fell back while the euro recovered somewhat, only to subsequently fall again. The general perception is that the ECB will follow the US and UK in cutting short-term rates.
Over recent months, our general approach has been to improve the overall credit quality of our portfolios. This has been achieved in two ways: first, by increasing exposure to investment-grade corporate bonds; and second, by increasing our holdings of government bonds.
The prospects are for continued weakness in the US economy in the coming months, with concerns over the decline in business and consumer confidence, the effects of the fall in the Nasdaq market and corporate restructuring and layoffs.
Increasingly, however, financial markets are looking beyond the current slowdown in economic activity and focusing on prospects for the second half of 2001 and 2002.
The US Federal Reserve has indicated it sees a quite sharp V-shaped recovery, with activity picking up in the second half of 2001.
But a more gradual U-shaped recovery is seen as more likely by many in the markets. The recovery will depend on the extent to which the Federal Reserve continues to ease interest rates: markets are already discounting quite a sharp reduction in interest rates.
But with inflation in the US still running at quite low levels, it seems likely that an even more aggressive easing will be possible if the economy remains sluggish.
A quick rebound in the US economy and a reduction in short-term interest rates would alleviate some of the current concerns about credit quality in the corporate bond market.
These developments will affect all corporate bond markets, not just those in the US, and will be important in setting the scene for the further substantial corporate bond issuance that is expected in the rest of 2001.
InvescoPerpetual Fixed Interest Department
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