Putting paradoxes into perspective
While the equity markets continue to grab the headlines, albeit for the most uncomfortable of reasons, the situation for bond investors is less frenzied but still vexing. Europe, in particular, appears to be presenting the most confusing environment for bonds. For example, although consumer confidence within Europe remains at historically high levels, industrial confidence has recently fallen sharply.
Commerz Asset Management’s Sonja Demann agrees that paradoxes abound, saying, “Europe is indeed looking like quite a mixed picture economically. On the one hand we see the GDP of the big four European economies starting to show more negative trends, while on the other hand we cannot ignore the fact that six of the EU economies have been cutting taxes, which will surely have a positive effect on the economies. All in all, we are still optimistic on inflation, and although it is over the 2% ceiling at the moment we think a variety of factors not least the stabilising oil price will combine to ensure that inflation will drop below the 2% level by mid-year.”
Some observers suggest European Central Bank president Wim Duisenberg may be opposing rate cuts because he is particularly concerned about inflation in his homeland. Consumer prices in the Netherlands leapt to a new high of 4.6% in March.
Whatever the true reasons for his opposition to easing monetary policy, many investors think the ECB needs to re-think its strategies. Demann suggests that the ECB has been wrong to dismiss the negative drag the slowing US economy will exert on Europe.
She explains, “On the face of it, 10–15% of our exports go to the US, but if you also factor in a weakened Japanese economy then that combined effect will have a marked impact on global growth. Looking at the money supply and the current inflation figures the ECB’s ‘hold-strategy’ is perhaps understandable. But I share the same opinion as the market that the ECB is behind the curve and will probably start cutting rates towards the second half of the year.”
Others believe that the ECB will not want to wait that long. According to Metzler’s Nader Purschaker, the ECB has recognised that the risks to European economic growth are increasing. “There is growing scope for the ECB to ease the monetary reins and we expect rates to be lowered by 75 basis points by mid-year. On the prices front there are signs that pressure is now easing and we think that inflation could drop back below 2% by the middle of the year.” Purschaker points out that growth in M3, one of the main pillars of monetary policy, is shifting back down towards the benchmark level of 4.5% which indicates that the medium-term risk of (higher) inflation is declining.
For SG Asset Management’s Veronica Bats, trying to second-guess the ECB’s rate-cutting plans is unlikely to prove successful. “Working out what the Federal Reserve is about to do is so much more straightforward, because their process is credible and transparent,” she argues, “but for the ECB it is much harder for us to know what is guiding their decisions. And they barely comment after their meetings. One of their main objectives is to subdue inflation, and hence to try and work out what the level really is across Europe. If you look at the flatness of the yield curve in_Europe right now, that tells us that the market at any rate does not believe inflation to be a problem.”
After recent comments from some ECB members, Bats thinks that the ECB is now starting to become more concerned about the Euro-zone economy, with German economic weakness worsening and other economies showing signs too, but is not prepared to bet on the timing of the rate cuts. Although the US economy is very weak, SGAM believes that the Fed will not need to cut rates in-between meetings, a possibility being raised by several analysts in recent days.
With interest rate cuts in the offing, why is it that so many investors are not enthusiastic about government bond markets? It may be that bonds are running out of reasons to rally further. “Capital has been shifted into the ‘safe haven’ of bond markets in response to the weakness of equity markets,” says Metzler’s Purschaker, adding, “The lower interest rates in the US, and signs that the global economy is slowing has generated a positive mood in recent weeks. However, we now believe there is very little scope for further declines in bond yields because most of the anticipated reduction in inflation and interest rates is already priced in.”
“Bond markets have actually done very little over the last month,” asserts Bats, “and we believe that the short end of the yield curve has already priced in future rate cuts. And there does not appear to be too much danger at the long end. On balance we prefer Euroland although we are underweight in duration terms both the US and Euroland government bond markets. Within Euroland, we are playing a barbell strategy: long between seven and 15 years, overweight at the very short end and short on the one to five-year sector. We also like corporate credit, both in the US and in Europe, our bet being that credit should react favourably to rebounds in the equity markets.”
Purschaker suggests that interest rates would probably decline significantly if there were widespread fears of a global recession, but that this is not a likely scenario. On the other hand he voices the fears of many fixed income investors when he adds, “As far as we can see, at present the main risk factors for the bond market are profit-taking and a recovery in equity markets.” Bats agrees, adding, “If equities start to anticipate an end to the recession, then bond markets would have to re-assess their rate cutting scenarios which would mean rising rates at both ends of the curves.”