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Year of misery rolls on

The first half of the year certainly has certainly been a miserable one for government bond markets. As central banks across the developed world eased – some more aggressively than others – so yield curves began to steepen markedly. For most bond markets this also meant rising yields at the long end, as prospects for global economic recovery improved over the year. Of course, improving prospects for equity markets also suggested better times ahead for those bonds more closely linked to corporate health – that is, credit markets, but also the markets of the emerging economies. Although Argentina’s ongoing debt negotiation problems have tended to drag down the performances of all the Latin American markets, the JP Morgan Emerging Markets Bond Index Plus rose about 4%, which compares neatly with the 4% decline in the Global Bond index.
For some managers, the halfway point in the year should mark a turnaround in the fortunes of the developed markets, or so argues Roeland Moraal, fixed income fund manager at Robeco. He goes on, “We continue to anticipate lower interests rates short and_long worldwide. Financial markets seem to have become too optimistic on the outlook for economic growth through April and May. Global business activity remains weak, and labour reports out of the US, Japan, France and Germany have all started to show the effects of weaker growth on employment. Our base scenario focuses on a more severe setback for the corporate sector than is currently being discounted by the markets, and we expect this to affect consumer behaviour at some stage.”
While agreeing that it would be rash to discount completely the possibility that the US economy may falter in its apparent recovery, San Paolo IMI’s head of fixed income Roberto Plaja is firmly in the camp that believes the trend of rising interest rates is by no means over. He points out that US manufacturing has clearly bottomed, and that as the Fed has already acted to ease monetary policy, and the government’s fiscal easing is already under way, there should be little reason to doubt that the economy will recover. He explains, ‘We think that the sell-off in the Treasury market is only about halfway through, and we could see the US 10-year reaching 6–6.5%. There may be another 50 basis points cut from the Fed, so we think the curve is going to be stable to flatter.”
Of course, it is unlikely, and would be a very rare occurrence indeed that the upward trend in yields would be a straight line, argues Nikolaus Keis at HypoVereinsbank Research. “In cyclical terms, US Treasuries have had their day, primarily because we believe the US economy is finding a floor, but also because of the dual stimuli from both monetary and fiscal policy. That said, however, the extreme overvaluation of the Treasury market has already been considerably reduced, and the recent sell-off appears to have been exaggerated, which makes a technical reaction the other way more probable,” states Keis. He also believes that the poor economic and earnings numbers expected over the next two to three months may trigger further profit taking in the equity market and could help longer-dated Treasuries.
Another scenario that the team at San Paolo IMI is investigating, although giving it only a 20% chance, is the possibility that the US continues to recover then has another downward lurch, eventually creating a ‘W’ pattern recovery. “Unemployment claims are accelerating at their fastest rate since the early 1990s, and it is slightly worrying that the stock market is finding it such a struggle to recover,’ says Plaja. “If we do start to see signs of a double bottom forming, then clearly our bearish outlook for Treasuries would have to be reconsidered,” he states, adding, “So it is something that we are investigating at the moment.”
The managers at Robeco are putting a significantly higher weight on the chance that the US economy will indeed find it difficult to pick up momentum. Moraal believes that the string of stronger than expected economic data releases in April and early May have already been superceded by a series of weaker numbers such as jobless claims, the sharp downward revision to first-quarter GDP, and weaker home sales. “Overall we think that negative factors will prevail and the slowdown in the economy will be a prolonged one, and we do not agree with the idea that economic recovery is around the corner.”
Where these two managers do find some agreement is in the shape of yield curves in the Euro-zone. “We did have a steepening trade on in Europe because the market was not discounting enough easing by the ECB. It is largely discounted now although there may be a little bit more to go, and we have taken off these positions,” says Plaja, adding that the ECB probably has another 50bps of cuts still to do.
Moraal thinks the steepening trend may have more to go and certainly that the European curves will steepen more than the US Treasury curve. “We agree with statements from the ECB that much of the recent upward pressure on inflation is temporary,” he says, but cautions, “However the current slide of the euro, coupled with the unpredictable behaviour of ECB president Duisenberg does flag risks to this benign inflation scenario in the near term. We do not believe that the recent cut by the ECB will be a one-off and we think that it heralds a new, more realistic approach from the bank that will ensure a string of cuts to come.”
HypoVereinsbank’s Keis thinks that inflation is causing the ECB some headaches and that the board will find it psychologically difficult to cut rates. He goes on to say that, as long as the ECB bases its decisions on the basis of achieving medium-term price stability then the combination of slow M3 growth and slowing economic growth, should enable them to ease further but that it may well be a very tentative move. “We also believe that the ECB will be keeping a low profile around the time of the introduction of the euro notes and coins,” states Keis, “And that any bigger rate cuts may only be expected after the New Year.”

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