The events of 11 September are still causing repercussions in both the economic and political world....
The events of 11 September are still causing repercussions in both the economic and political world. In the US, we have seen interest rate cuts and approval from Congress for a $40bn bill to finance the rescue effort, reconstruction and security. In Europe, the European Central Bank (ECB) has cut its rates and we have also seen a reduction by the UK Government.
Investors have deserted equity markets for the safer haven of short-dated bonds. Sentiment, which had been moving towards corporate debt, swung back in favour of sovereign bonds and investment grade corporate debt suffered from liquidity issues. In the high yield bond sector, the correlation between equity markets and high yield stocks placed added pressure.
In the UK, short-dated bonds staged a strong rally in line with most bond markets as investors became increasingly risk averse.
In sharp contrast, longer-dated bonds lost ground as they were hit by concerns that further fiscal stimulus would occur at a time when inflation was already above the government's 2.5% target.
Looking at the international picture, Euroland bonds performed in a similar manner to their US counterparts, as short-dated bonds rallied strongly while longer-dated bonds were hit by fears over increased issuance.
Going forward, we believe the outlook for global bonds remains good but there are a number of factors likely to dictate the level of returns in the coming months.
At present, the uncertainty over the final outcomes in the political and economic world lead us to believe the market will become increasingly focused on issuance and the relatively safer haven of sovereign bonds.
While short-dated bonds have outperformed, the US Government's decision to eliminate the 30-year bond auctions is expected to cause some strengthening in the long bond markets. The move came as some surprise to the markets, although it appears the Treasury may repurchase smaller amounts of stock in the future.
We expect this will lead to an increase in short-term issuance as the Fed is keen to move short rates lower to provide stimulus to the economy.
In the corporate bond market, merger and acquisition activity is likely to remain subdued in the current environment with lead supply being reduced accordingly.
Technical support from the abolition of the Minimum Funding Requirement should continue to provide additional demand in the corporate bond market. But, in the short term, economic news will get worse and yields should fall.
The key market is the US, where we expect the bond market to lead the way both down and up. Over the medium term, we are bullish on prospects for US bonds as we believe the economy will be rising by next year.
Looking at interest rates, we expect to see US rates come down, possibly below 2%, which would lead to rate cuts in Europe. In this environment, we could see UK rates go lower but we believe the UK economy is in a stronger position than Europe and the US. In this environment, we are looking for the yield curve to continue to flatten, particularly if the world's economies strengthen next year.
US economy expected to recover next year.
Favourable conditions for bond markets.
Corporate bonds appear good value.
Potentail early equity recovery .
Corporates suffering from liquidity iissues.
Short-dated bonds fully valued.
Peter Rains is head of fixed income at Morley Asset Management
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