The sharp inversion seen at the long end of the gilt market last year caught many fund managers, par...
The sharp inversion seen at the long end of the gilt market last year caught many fund managers, particularly international, on the wrong foot.
As the yield curve continued to invert, market commentators stated that this was an anomaly, which would be corrected in due course, and advised switching into higher yielding European bonds. However, the UK curve remains sharply inverted, despite switch auctions offering the prospect of increased ultra-long supply, and the long end of the US yield curve has inverted in anticipation of the Treasury buy-back programme.
We believe that it is the upward sloping European yield curve that is the anomaly, and the current yield pick up of 60 basis points between 10- and 30-year European bonds offers good value. In the longer term we expect to see this spread turn negative.
This year the flattening bias will come from the short end as the ECB raises interest rates in response to the improved economic outlook for Euroland. In the longer term, the main driver for a flatter yield curve will come from demographic trends. These suggest that the largest segment of the European population will have entered the 35 to 60 age group within the next ten years and will thus have turned from net spenders into net savers.
At the same time the dependency ratio will rise sharply which will make the financing of state pensions increasingly untenable. We believe this will force European governments to move towards providing a funded state pension scheme or to encourage the private sector, as in the UK, to provide such a vehicle. To match these liabilities, funded pension schemes must invest a significant proportion of their assets in long-dated bonds.
However, at a time when the largest proportion of the European population is turning from big spenders to big savers, the Maastrict treaty requirements are constraining government deficits and therefore debt issuance. For the four largest countries in Euroland, gross bond issuance is expected to decline by e25bn in 2000 relative to last year, and net bond issuance by e15bn. The 'net liquidity injection', the excess of coupon payments over net issuance, should shift positively by e19bn to e1bn. This trend should continue for the foreseeable future as Europe enjoys a strong cyclical upturn.
Despite the difficulties the authorities have encountered in France and Italy in attempting to introduce funded pension schemes, we feel the move will occur. Support is likely to come from policymakers at the European Commission. They appear to be aware of the potential conflict caused by the demographic changes and the Maastrict treaty and have recruited economists to investigate the impact of reduced government bond supply. We expect this will lead the Commission to press national governments to reform their pension systems and introduce funded schemes.
Given the well-documented problems of the UK following the introduction of the Minimum Funding Regulations, we expect the impact on the long end of the European yield curve to be much less powerful as solvency rules and funding policy are adjusted in light of the UK experience.
However, the story of increased demand for long dated assets at a time of diminishing supply is similar to the position the UK currently finds itself in. We expect this to lead to a sharply flatter European yield curve as long dated assets develop a scarcity premium and believe that the 10- to 30-year spread will eventually turn negative. This conflicts with classical bond market theory but reflects the underlying supply and demand imbalances that will come to characterise international bond markets.
David Hooker is assistant director at Royal & Sun Alliance Investment Management
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