The short-term outlook is that bond markets are still vulnerable to strong economic growth and more ...
The short-term outlook is that bond markets are still vulnerable to strong economic growth and more aggressive central bankers.
However, aggressive monetary tightening by the US central bank, in particular, increases the chance that we will see the peak in bond yields sooner than we thought. So, the ideal strategy would be to buy bonds now and go long if yields spike higher. In order of preference, we favour US Treasuries, UK Eurosterling, and European long-dated governments.
In the US, it is clear that recent monetary tightening is insufficient to slow the economy and that only a domestic shock is likely to cause the economy to decelerate. This could be engineered by the central bank in the form of higher than expected short-term interest rates, which is likely. The US bond market has yet to fully price in this scenario and remains vulnerable in the short-term.
That said, with yields approaching 6.75% and inflation unlikely to remain above 2.75% for a meaningful period, real yields at 4% are attractive. A sustained rally in US bonds will have to wait until the market can see a period of economic weakness and/or inflation is clearly declining once again. A difficult first quarter can be expected as the reported economic data is likely to remain strong and the Federal Reserve attempts to rein in excess demand.
A healthy budget surplus is one of the positive by-products of strong economic growth and will reduce the amount of government bond supply going forward as the recent US Treasury bond buy-back announcement shows.
The situation in the UK is similar with strong economic growth and a tightening bias by the central bank causing bond yields to rise over the next few months. The shortage of issuance is especially pronounced in the long-end of the UK yield curve - a situation that is causing particular problems for UK pension funds. At some point this supply/demand imbalance must be resolved, as it cannot be in either party's interest to continue.
As usual the European economy appears to be a few months behind the economies of the UK and US and, therefore, its interest rate tightening cycle has a lot further to run. As a result, the short-end of the European market still looks unattractive.
Once the Japanese economic recovery moves to a more sustained level of growth the zero interest rate policy will be removed and rates will gradually move higher. The prospect of higher short-term interest rates and the high level of Government bond supply during the year will make the Japanese bond market the least attractive in the year 2000.
In summary, government bond markets will struggle in the first few months of 2000 as strong synchronised economic growth combines with tighter monetary policies and higher headline inflation. The higher yields available will prove attractive once there are clear signs that economic growth has stopped accelerating and that the central banks are close to ending their current bout of monetary tightening. The current increase in inflationary expectations is unlikely to be sustained over the medium-term, paving the way for lower bond yields once again.
Non-government spreads such as corporates and emerging markets are currently at fair-value levels. These could be pushed wider in the short-term as the relative supply story favours Government bonds. Longer term, these markets will be in increasing demand as investors seek alternatives to the low yielding, less liquid, government bonds.
Paul Brain is fund manager at Investec Guinness Flight
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