Europe follows Greenspan’s lead
A minor inflation scare in the US and the Federal Reserve Board’s response will be one of the major issues for European bond investors over the next few months. Although the evidence for inflation is only sketchy, it was enough for Fed chairman Alan Greenspan’s statement this week to be more explicit than normal in defining the Fed’s policy stance: no hike in rates but the likelihood of rises to come before the end of the year.
Ashok Talukdar, fixed interest manager at SSB Citi Asset Management says that, “Macroeconomically it’s been more of the same – strong growth in the US and central banks keeping a close watch on inflation. The Fed cut rates by 0.75% on the basis of external issues in the global economy. Now with Asia and the emerging economies looking relatively stable, the forward market is factoring in a couple of rate rises in the US between now and end of the year.”
In Europe, the markets have been sluggish by comparison. European bond yields for the core nations have remained largely un-changed, just above the 4% level and managers feel bonds are likely to trade sideways for the foreseeable future.
Rod Davidson at Murray Johnstone in Glasgow suggests Europe has suffered a bit of a setback because of the movement in the US and during the summer months the market will be affected largely by what happens there.
Talukdar adds that despite the talk of growth in Europe this year, it’s not coming through, particularly in Germany and Italy, who are the laggards. This is in contrast with the euro bubble occurring around the periphery, in Spain, Portugal and Ireland: “The core is not growing sufficiently to warrant a rate rise. So it’s a test for the ECB.”
The ECB has been relatively quiet, apart from noting that the euro was weak but that it wasn’t too concerned. Davidson suggests the central bank’s room for manoevre is fairly limited in the short term: “There doesn’t appear to be much room for further easing of rates this year. This could change if the euro strengthens, but the ECB will be concerned to keep an eye on inflation in Spain for example, which is up to 2.5% against the average of 1.5%.”
Barings’ head of fixed interest Mark Pignatelli expects Euroland to experience a period of profound deflation in traded goods and a reflation in non-traded goods: “The introduction of the euro has allowed a perfect pricing transparency for traded goods within the new single currency block. Price differentials of more than 40% in many standard goods can now be arbitraged between countries in a way that was not possible whilst a currency risk remained.”
The ECB, meanwhile, will not be able to set a monetary course that simultaneously targets both inflation and money supply. Given a choice between setting interest rates that are appropriate for inflation or suitable for money supply growth, the ECB will be left with only one option.
“It simply cannot take the risk of being seen to have set interest rates at a level that impeded growth at a time when there was zero risk of inflation,” says Pignatelli.
“The implications are that as interest rates fall further, the demand for money will increase.”
Wim Duisenberg may aspire to the considerable influence wielded by his US counterpart, but until his pronouncements do carry such credibility, the ECB will still be seen as an institution that’s vulnerable to political pressure.
According to SSB Citi Asset Management’s Talukdar: “Greenspan has enough credibility that he can get the short end of the bond market to pretty much do what he wants.”
His outlook is that the market looks a bit oversold at present, but that there won’t be too much movement either way. “Three months from now, I don’t see much movement, high or low.” And overall Murray Johnstone’s Davidson feels that if European bond yields go to 4.5%, “that represents an excellent entry point”.
In times like this, what’s probably of more interest to a European bond manager is playing core euro land off against the periphery, including central Europe, the UK and Scandinavia.
As Talukdar says, “There is now a clear belief in the euro convergence programme across euroland and as far afield as Hungary. And even if German bunds rally, it’s not going to affect the spreads to markets such as Greece particularly badly. That flight to quality that might have been expected, did not happen.”
On the assumption that the Czech Republic, Hungary and Poland will be ‘in’ by 2004, and that they?ll be in the single currency two years after that, there’s a lot more to be made in peripheral bond markets that are still sovereign.