For some time the key issue dominating global bond markets has been whether the US economy can pull ...
For some time the key issue dominating global bond markets has been whether the US economy can pull off a soft landing, avoid a significant rise in inflation and prevent the need for several further rate increases. Investors have nervously been following any news which might provide some clues on the outlook.
We believe the US economy is in the early stages of an economic slowdown, albeit one that is not sudden or dramatic. The magnitude of the slowdown is vitally important. Unless levels of activity fall to below the long-term potential of the economy, capacity constraints will continue to be exceeded and inflation is very likely to result.
However, while business and government spending has grown, inflation has remained under control at 2.5% and consumer spending growth has declined. US consumer spending commands a two thirds share of overall GDP and it is the American consumer's robust appetite that has not only driven strong growth in the US over the last couple of years, but has also sustained the recovery around the rest of the world. All eyes will be on the path of consumer spending over the coming months. In addition, and this is the biggest risk for global bond markets, will inflation accelerate and require a vigorous response from the Federal Reserve?
On a comparative basis, the greater inflationary dangers appear to be in the US, rather than in Continental Europe or the UK as this is where capacity constraints, particularly in the labour market, are most acute. At the current levels of yield, the market has chosen to virtually ignore the possibility that inflation will deteriorate much further; and we believe that this is too sanguine a view and therefore see the market as fully valued at current levels.
In Europe, we also believe that the market is overly sanguine about the outlook for rates. A rise of 50 basis points in September is a distinct possibility. The prospects for further tightening by the ECB have caused us to hold a barbell position in anticipation of further flattening of the yield curve.
The Japanese bond market is near the bottom end of the range that has persisted for over a year and is very expensive from a strategic perspective. The Bank of Japan has hinted at a forthcoming rise in overnight interest rates from its zero rate policy, but this is predicated on evidence that the economy is embarking on a self-sustaining recovery. While the recent bankruptcy of the Sogo department store and the weak Nikkei caused the Bank of Japan to delay this intended move, recent rhetoric suggests that it is imminent.
Any rise would be the first since 1990 and is likely to be taken negatively by the bond market. As a result, we retain a defensive stance towards the country's government bonds.
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