Bond markets overshooting?
Bond markets are approaching the end of this millennium in fairly flat mood as a consequence of the strong prospect for global growth and higher inflation. This supports the view being put forward that yields at current levels offer relatively good value.
Until November global financial markets had seemed weighed down by concerns that the Fed had fallen behind the inflation curve. This view was revised following upward revisions to GDP data and productivity gains which resulted in economists raising estimates of non-inflationary growth.
The Fed then announced that the federal funds rate would be raised a third time from 5.25% to 5.5%, thereby completing the removal of the 75 basis point cut last year at the time of Russia and Asia crises. Some analysts think the 25bp increases in the discount and federal funds rates will suffice, while others foresee further tightening.
The recent decline in bond yields and slowing of economic growth point the way to an eventual lowering of market interest rates. The consensus view is that the Fed will want to wait and watch the effects of the Y2K period before deciding its next move.
In Europe, interest rate rises were announced by both the ECB and the Bank of England. The ECB raised the refinancing rate by 50bps to 3% mainly on inflation concerns. Meanwhile, the Bank of England raised interest rates by 25bps to 5.5% to combat house price inflation, strong wage growth and buoyant consumer spending. Both interest rate rises were anticipated and already priced into the market.
The medium-term inflation outlook for the Euro-zone is positive in terms of the ECB’s target of keeping inflation below 2%. According to Ian Dixon, global bonds fund manager at Henderson Investors, if this is right, “there is little justification for a nominal yield in excess of 5% (on a 10-year treasury) and over the next 12 months we would expect yields to fall from present levels”.
In the UK, the spread between gilts and euro-bonds has narrowed. Henderson’s view is that with hopes of an early EMU entry on the decline, a 40bp spread looks too low and the forecast is for gilt yields to be around 0.6% higher than Euro-zone yields in a year's time.
Schroder’s Tom Joy, manager of the group’s Euro Bond fund, takes the view that expectations of the future path of short-term interest rates are pricing in more rate rises than are justified: “In itself this is not sufficient to become positive on bond markets as historically, when bond markets are in a bear phase and interest rates are rising interest rate expectations tend to overshoot. For bond markets to turn around and yields to start falling again an economic catalyst is needed to suggest growth is slowing or inflation is falling again. While bond markets appear to be overshooting and there is medium term value at present, it is too early to take a positive stance towards markets.”
Barings’ European bond manager Jeremy Yeats Edwards suggests that with continued disparity in economic growth rates between countries, with Spain, France and the Netherlands outstripping Italy and Germany, “the attitude of the European Central Bank is, to some extent, a mystery. Conflicting statements from European central bankers have as their common thread the idea that no inflation threat exists currently and that the next move when it comes will be upwards. Against this background and with GDP growth of 2.5% in 2000, we would expect short rates to be readjusted back to 3% levels at some point next year. This would be accompanied by a flatter yield curve and further recovery of the euro back to 1.10 levels.”