World bond markets face several near-term challenges, which will create dull investment conditions n...
World bond markets face several near-term challenges, which will create dull investment conditions now but will provide a buying opportunity for those able to take a less immediate view.
The key issue is the development of the US economy. Sustained growth is forcing forecasters to raise their expectations for the pace of expansion, with predictions of a 3% rise in activity in 2000 giving way to well over 4% - and even more than that in the first half.
Growing activity elsewhere in the world has helped to keep conditions bubbling but the real source is the consumer who has dropped the savings ratio down to around 1.5% and ignored signals which in the past have led to more sober activity levels.
Neither higher interest rates nor a sharp setback in broad areas of the equity market have changed expectations. But inflation is creeping higher and could reach 4% this year. Rates will rise to give a sustained squeeze, to deflate expectations gradually.
European growth expectations are rising and an outturn of about +4% seems likely. The economic cycle is too young to have any real concerns about inflation short term, but rates will still move higher. That longer yields have already done so reflects developments elsewhere in the world and the poor credibility the ECB has managed to achieve.
Japan's recent lapse back into recession understates the slow improvement taking place. A better tone to global activity levels and, in particular, recovery in Asia, easy monetary policy and a willingness to spend - at least by the government - should produce growth of about 1% to 1.5% this year, skewed towards the second half. Longer term Japan will suffer from the volume of bonds being issued which will force yields higher. But for the near term, with prices lower in recent months, there is good reason to look for stability and relative strength.
The wild card is the impact of the oil price on inflation. Energy efficiency has improved vastly since the 1970s and 1980s so higher prices do not have the same impact now. The oil futures market has remained sanguine, discounting lower prices ahead and Opec sources are hinting at increased production. But markets might be too relaxed as Opec is already producing over quota, and with petrol stocks at a 15-year low and the driving season about to begin, prices may well stay higher for longer.
A background of rising interest rates, accelerating growth and inflationary risks is why bond markets have been dull. We do not expect them to change in the near term and expect yields to rise modestly in most markets over the next few weeks. Our strategy is defensive and we are short duration in most markets. One area of relative attraction is Japan. Also in the US and UK shortages of government bonds have enhanced the attraction of good quality credit. We remain long of the US dollar and sterling and cautious of the yen and the euro.
John Kelly is investment director at Barclays Global Investors Funds
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