Bond yields have risen markedly in recent months. In the US, they began rising last October; in Euro...
Bond yields have risen markedly in recent months. In the US, they began rising last October; in Europe, they began in early February; in Japan, they started only as recently as late May.
The rise in yields has undoubtedly been caused by shifting perceptions about economic growth. The US has now been growing more or less continuously for nine years. The employment market has tightened to the extent that there are actual labour shortages and the trade deficit has ballooned out to record proportions.
However, upward pressure on the domestic price level has been contained both by intense competition from Asia and by the technological revolution that is sweeping the country. Following last year's Asian crisis, the Fed cut rates in order to forestall any systemic problems amongst the US banks. However, unlike in previous episodes, it did not subsequently tighten when the crisis subsided. There has thus been an additional monetary stimulus to an overheating economy and the bond market has taken serious fright.
In Europe, the much-heralded economic recovery has been very slow in materialising. The European central bank accordingly felt obliged to lower interest rates sharply in February in order to provide an offsetting stimulus - just at the point when the economy was probably beginning spontaneously to recover. Meanwhile, in the UK, the Bank of England also continued to reduce interest rates - just as the growth recession started to reverse. Again, the bond markets have taken fright.
Finally, in Japan, the massive fiscal stimulus that has been cumulatively applied to the economy in the last two years finally began to impact on growth in the first quarter. Furthermore, the Bank of Japan - which has kept short-term interest rates virtually at zero in order to protect the integrity of the beleaguered domestic banking system - now has the problem of adjusting interest rates without aborting the recovery. Inevitably, it will be slow to react - and the bond market is beginning to worry about the resulting overstimulation.
Some of the fears are well founded. Commodity prices have bounced, led by oil. Bond markets fear that, because prices of industrial goods are being restrained by surplus capacity in Asia, the authorities may err by being late in responding to economic recovery.
Nevertheless, it is arguable that the bond markets have now become too concerned about inflationary pressures. In the US, the Fed has finally increased interest rates by 0.25% to 5%, thereby signalling some degree of determination to address the problem. In the UK, the futures market is now anticipating a rise in short-term interest rates to more than 7% by early 2001. In continental Europe, the core economies are only in the early stages of the recovery so bond markets now offer value.
Furthermore, there is the effect of demography. The 'Baby-Boom' generation is already nearing its maximum propensity to spend. Older boomers already have a revealed preference for income over capital growth and the time is arriving when this pressure will intensify. Logically, they should switch from equities to bonds. This makes an extended bear market in bonds increasingly unlikely.
Tony Plummer is a fund manager at Investec Guinness Flight
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