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Why Europe offers better value

As 2003 gets under way, predictions for the fixed income markets are becoming ever more vague, and fund manager opinion increasingly mixed. Uncertainties regarding economic recovery in Europe and the US, combined with the unknown possibility of a war in Iraq are rendering forecasts for bond yields a matter of sheer guess work.
Given the weakness in the European economy, a final 25 basis point rate cut from the European Central Bank in March–April seemed inevitable last month, but fixed income fund managers are now not so confident.
Says Pierre Vanhove, head of duration and yield curve positioning at Fortis Investment Management in Paris: “We still expect a rate cut at some point from the ECB, indeed the market has priced in the ECB rate below 2.75% but if the Fed does hike rates, then further easing by the ECB will fade away. We don’t believe the Fed will raise rates before the second half of the year, however.”
Han de Jong, head of investment strategy in asset management at ABN AMRO in Amsterdam, on the other hand feels that room for ECB rate cuts goes beyond a 25bp snip. ”I wouldn’t be surprised if it is more than the 25bp expected. In fact, I see room for a further four cuts.”
Where you see short-term bond yields going depends on which fund manager you agree with. If de Jong’s theory is right, the short end certainly looks attractive. As he explains: “There may not be much value, but risks are not large and there are gains to be made.”
Ulrich Katz, senior fund manager at DIT in Munich, does not agree. “We’re still positive on bonds, and believe the Bund curve will remain steep at the front end. But we don’t like the two- and three-year – it’s too expensive. The two-year, for example, is yielding around 2.69% and repo rates are yielding more. We instead prefer short-dated Pfandbrief.”
The effect of a war in Iraq on bonds is equally mixed, governed by personal opinion as to its length and outcome.
Says Katz: “The Iraq crisis is likely to be positive for bonds, but a war will hurt the European economy as oil prices increase, and ultimately fundamentals will decide. So if there is a positive effect on bonds it will probably only be short-lived.”

Indeed, it is difficult to judge what the effect of a war would be. While the text-book theory of a ‘flight to quality’ would be a sensible prediction, de Jong points out the fact that after the start of the Gulf War in 1990 10-year US Treasury yields remained largely range-bound. So fund managers will do well to shrug their shoulders and reply ‘who knows?’
Vanhove believes that if a war does occur with Iraq, and it is short, many uncertainties will be removed, restoring US consumer confidence, and leading to a gradual shift in asset allocation away from risk-free assets and towards riskier assets such as equities, emerging markets and corporate bonds. Such a shift, Vanhove believes, will develop at the expense of government bond yields. “By the end of 2003 we see the 10-year US Treasury trading between 4.5% and 5% and the 10-year Bund 4.5% to 4.75%.”
With regard to long-end yields, Katz does not agree that 10-year Bund yields will rise this year. Rather, Katz sees yields falling to 4% by the end of the year. He agrees, however, that the UST 10-year yield will rise, but is more cautious – estimating a rise above 4.25%.
Enter de Jong to further confuse matters: “The house view is that bond yields will stay close to their current levels. There will probably be a downward trend for yields, but with steep pullbacks at times.”
One consensus, however, is that European bonds will offer greater value than their US equivalents. An eventual economic recovery in Europe can be agreed by all, as can the fact that it will arrive later than a recovery in the US. A weak economy in Europe, further rate cuts (regardless of size), and a continued weak US dollar result in a strong case for Euro-denominated bonds – just don’t ask at which end of the yield curve.

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