The European Central Bank may have cut interest rates five times in 2002, but the market opinion is that “it’s not over till Wim Duisenberg sings”. Over the 12 month period, the ECB slashed the interest rate by 2% – the last cut arriving in December – but market participants feel there is still room for more, which takes a little pressure off bonds as we enter 2003.
It had largely been believed that the ECB would go for a quarter point snip in December, which had been firmly priced in, but following the half point cut by the US Federal Reserve in November, the ECB’s own 50 basis point cut was not an entire surprise.
Still, the effect of a larger than expected rate cut, following a series of rate cuts, is that market participants question whether this is the last one, and they begin to speculate on the future of interest rates and bond yields.
In the US, where rates are now very low the question of whether we have seen the last cut is an easier argument than in Europe, believes Martin Hall, head of fixed income at Fidelity in London. “For Europe, where the extent of economic weakness is greater, and there is still the question of whether this will continue into next year, the jury is still hung, and there may well be room for more monetary policy easing.”
The ECB’s chief economist himself, Otmar Issing, hinted at room for manoeuvre in an interview with German economic magazine Capital in December citing lower rates in Japan and the US as a reason. Kenneth Broux, economist at Thomson Financial, believes that if a rate cut is to come it will be a quarter point snip, “but we probably won’t see it until at least March 2003.”
But Hall does not believe that the market focus is solely on interest rates. “Market confidence in the world is crucial, and an interest rate cut is not as significant in the short term as what is going on in the world more generally, notably in the form of geopolitical risk.”
Inflation, economic growth and risk aversion are all key in forecasting the future of the bond market, and with expectations of sluggish global economic growth, and a low inflationary environment, government bond yields should be protected in 2003.
Says Laurence Mutkin, director of fixed income strategy at Threadneedle Investments. “We expect inflation to remain very subdued. There is no real sign it will turn up, and global economic growth although not negative, is below trend. The UK is probably better on the growth stakes than the US or Euroland, but we are certainly not looking at the high levels of growth that will worry anyone in terms of tightening monetary policy.”
“We expect much a continuation of last year, and it is a difficult environment for the bond market to do badly in – that is, one of low nominal growth. When nominal growth is low, then assets that give you nominal yield are favoured, so we don’t think government bonds have much scope to fall.”
Tim Webb, head of credit investment process at Barclays Global Investors agrees: “although government bond supply looks likely to increase as a result of deteriorating public sector financing, the low inflationary environment should ensure that government bonds remain underpinned in 2003. That said, if monetary policy is loose enough to stimulate growth of the US and European economies, then government bond yields could rise at the back-end of 2003.”
For corporate bond markets, risk appetite will be the driver in 2003. BGI remains cautious. Says Webb: “2001 and 2002 were characterised by a high level of credit downgrades and corporate announcements. So that instead of one or two significant credit events, last year there were probably 30 or 40 names that saw significant credit spread widening. Every area has seen bonds fall into sub-investment grade and their bond spreads widen dramatically, be it the insurance industry, air, leisure, energy, hotels, steel.”
“So we remain cautious. Higher quality bonds will remain well supported, although they don’t offer much value, and in the credit market we remain defensive. So although we’ll try to move down curve to single A and triple B paper, we’ll be looking at defensive sectors like water, UK financials, transport sectors, and also asset backed securities.”
Risk appetite will also be the determinate for high-yield bonds. The rally in stock markets since early October lows as risk appetite has grown has greatly benefited the lower-rated credit markets, and high-yield and emerging market bonds have performed well since. Mutkin attributes the performance to a combination of a fall in risk aversion, and the affect of easier monetary policy which benefits highly leveraged borrowers – such as high yield market. Says Mutkin: “Going forward, it depends what happens to risk aversion as to whether the strong performance of lower-rated credits will continue. It will depend on: stock market volatility, which although has fallen from highs could go either way; geo-political risks; and the economic situation of developed world which is unimpressive.”
Says Webb: “If there is a pick up in global economies in 2003 then the high yield sector will do well. However, investors have had their fingers burnt, trying to catch falling knives as investment grade bonds drop into the high yield arena. It is not an easy game to play. We imagine there is further equity market weakness going forward, so we expect some weakness in high yield sector.”
Colin Harte of Baring Asset Management feels the high-yield market offers value. “High yield bonds are priced for a worse scenario than statistically likely. Better quality credits will be more susceptible if there is a macroeconomic shock of stronger growth. The investment grade market will get hit along with government bond markets, and the yield spreads will not give you a good deal of protection. Lower quality paper, on the other hand, does give you a lot of protection.
“Also in many ways, lower-rated companies are easier to read. You can drill down and get a better understanding of the businesses, whereas many of the investment grade companies are complicated businesses, such as Enron, and it is difficult to see what is on the balance sheet. So paradoxically, it is easier to assess the risk of the lower quality companies.”
Going into 2003, bond investors are holding steady, and there is a strong sense of “waiting and seeing.”
Says Harte: “Although market participants would like to see a dampening down of market volatility and a clearer pattern of trends emerge, I suspect over the course of next year the key feature will be continued high levels of volatility and markets will flip from believing everything is wonderful to everything is dire. So I wouldn’t be surprised if we saw replays of 2002. You’ve got to be prepared to move portfolios around to bet against all extreme positions the market will take.”