Limited room to move
Job creation and a taster, at least, of higher inflation – what more could bond markets need to convince themselves that they’re in a bear market? “It’s fair to say that March was a bit of a blow-out month for the US economy,” say the managers at Robeco. “Not only did employment and inflation rise but consumer spending grew, as reflected in strong retail sales, and also strong durable goods orders also pointed to rising capital spending too. The end of the era of disinflation is here: Federal Reserve chairman Greenspan stated as much saying: ‘the worrisome trend of disinflation has come to an end’. We think our bearish fundamental view on US interest rates is now very well supported.”
“US interest rates do have further to go up, and maybe a great deal further,” warns Christine Farquhar, head of fixed income at Lombard Odier Darier Hensch (LODH). “The market worried itself nearly to death over the non-farm payroll numbers and now the same could happen as attention turns to inflationary concerns.” Farquhar goes on to argue that although the LODH view is that structural inflation is a thing of the past, there can be little doubt that inflation is back cyclically with a significantly higher oil price and rising commodity prices generally. “The market is right to be pricing in rate rises from the Fed, frankly we would be astonished if the they did not make a move in this economic environment where US rates are still, effectively, at emergency levels. However we think that it would be hard for the Fed to move any more than the 75 basis points priced to the money markets in by year-end.”
Investors agree that although US rate rises are a virtual certainty, Fed chairman Greenspan is still going to need to exercise extreme caution as they go. Allianz PIMCO expect that this will be a risky time for the Fed as Munich-based Matthieu Louanges explains: “Green-span will be very careful as rates are increased, well aware of their sensitivity given the very high levels of public and private debt and the state of the housing market. We are entering a time where all risky assets, be they high yield corporate bonds, equities, emerging markets, commodities or even Treasuries themselves are under pressure. There’s a huge unwinding of carry trades as the cheap financing rates disappear and all ‘risky’ asset classes will be in some trouble.”
As well as sharing the conviction that, both short and long US interest rates will be even higher by year end, many investors also agree that although the economic climate on this side of ‘the pond’ is considerably less dynamic European bond yields might have difficulty completely decoupling from US rates. Although managers point out that in relative terms European bonds have been outperforming US Treasuries yields have still risen in Europe. Most of the ‘outperformance’ relative to the US market has been seen at the short end on the expectation that European short term rates won’t be raised as much as those in the US.
“Even thought one of Germany’s most widely watched indices of consumer confidence the ICON has actually bottomed, the reading is only hovering at the 100 mark suggesting that pessimists still outnumber optimists,” says Robeco’s Ronald Balk.
On the other hand, he and his colleagues believe that the most recent activity indicators do give some hope for a gradual pick-up in economic activity in the Euro-zone, pointing to the German Ifo survey which unexpectedly showed an upturn in April, an increase entirely driven by a rise in the ‘current conditions’ component. They point to indicators in other countries, such as the Netherlands and Italy, showing a similar pattern and believe that these series (of indicators) are turning upwards albeit from depressed levels.
“But we think that the ECB is a long way from tightening its monetary policy,” says Balk, “And consequently we believe that the short end of the Euro-zone curve should continue to do relatively well.” Robeco have implemented a yield curve steepener position for the Eurozone bond market, in contrast to their flattening strategies in place in the US market.
Although rather less bullish in her interest rate outlook, LODH’s Farquhar agrees with that general tone. “We would describe the short end of the Euro-zone yield curve– that is two to five years’ maturities – as possibly the least dangerous place to be. We believe that yields do have further to rise, but that we are probably nearer the top in Europe and the UK.”
Others remain quite pessimistic about the growth picture in the Euro-zone, and thus more optimistic about the prospects for rates. “The performance of the German economy is so disappointing,” says Louanges. “Industrial production declined 2.3% during March, much worse than the 0.6% rise which the market was expecting. And unemployment has climbed to 9.8%, which means there are 4.4m unemployed across Europe.” Louanges suggests that the Euro-zone’s problem stems from the lack of internal demand, arguing that unemployment has been rising as an initial (negative) consequence of the first round of structural reforms. He adds that effectively, there fiscal policy is not providing any stimulus at all, unlike in the US where consumers have enjoyed significant tax cuts.
Louanges believes that the market, now pricing in some rate increase from the ECB before year-end, will be proved wrong. “It is so unlikely that we will see a rate hike,” he says, adding, “in fact I would suggest that the likelihood of them cutting rates is probably higher. With inflation running at 1.7% year-on-year in March, there is room for a rate cut. Should the US market have another sell-off, 10-year and longer maturities in the Euro-zone will be under pressure. However the front end, which is much more strongly linked to central bank policy and expectations and domestic issues, could actually fall. So we do see good value here and our portfolios are strongly overweight in the medium part of the yield curve.”