After the summer doldrums came the autumn nerves, and now we seem to have entered a new phase, although no-one seems quite sure if it is safe to join in just yet.
HSBC prefers to describe the bond market move at the start of December as an “uncontrollable rally”. WestLB’s Dieter Ritter takes a slightly more sanguine approach, although he agrees that the market might have got ahead of itself again: “This yield decline in the US is associated with growing expectation that the US may be on the verge of recession, and may be landing hard. We do not see this scenario panning out. No, we think that growth will moderate in this fourth quarter to about 2%. But there is not going to be a recession next year. Our forecast is for growth of 3–3.25% for the year 2001.”
For other investors, the recent rallies mark the start of a new lease of life for bond markets. Dublin-based Setanta Asset Management’s John Looby says he believes that the recent rally “reflects the reality that the US economy is slowing down. I think it the_market is pricing in a soft landing with the attached risk that the economy may slow down beyond trend requiring the Federal Reserve to come in and loosen. We have had an accumulation of weaker US data over the last few months, in what I would call the traditional economy. The NAPM has been softening; the housing market has been hit by the higher interest rates; and the stock market declines are starting to cause the consumer to pull back.”
Looby firmly believes that with the US two-year at 5.5% and Fed Funds at 6.5%, the market has got it about right. The managers at Brussels-based Cordius pretty much agree with the scenario being painted by the market, highlighting a change in their own forecasts: “Over this last month we have changed our monetary policy forecasts for the coming months, and we think that the Fed will abandon its restrictive stance in favour of a neutral approach before relaxing its intervention rates.”
However, Cordius does not admit to being quite as keen, as the market is in its expectation that this change in monetary policy is an imminent. The firm explains: “Unlike many market participants, we believe this policy relaxation will occur until after the second quarter of 2001.” Cordius continues to argue that inflation and unit salary cost will cause some discomfort early in the New Year, and while agreeing that the market is about right as things stand and having upgraded its outlook from slightly negative last month, is not prepared to move into bullish mode.
For the more bearish WestLB, the best place to be on the US Treasury curve is between twos and fives. WestLB’s Ritter explains, “ For 10-years to be 150 basis points below Fed Funds is not right. We would definitely not suggest anything longer than five years, and might even go so far as to say stick with FRNs!”
Along with the bond market’s move to the ‘hard-landing’ for the US scenario, the currency markets seem to have had some loss of faith in the mighty US dollar. “The euro has bottomed, of that I am quite sure,” asserts Looby, adding that the slowing down of the US economy is a definite detractor for the dollar. He goes on, “We have seen massive flows of direct investment and portfolio monies heading out of Europe and into the US, but I believe that tide is already starting to wane as the US becomes a less attractive ‘destination’.”
WestLB also thinks that things may be looking up for the euro. Ritter explains: “The narrowing of the growth differentials between the US and here in Europe is supportive of the euro. Also, the less positive stock market could drive down the M&A activity of European companies in the US. But I would stress that our six-month forecast for the euro is 92 cents to the dollar, and we are almost there. We are not major bulls especially as we are more bullish than the market consensus about the growth outlook for the US economy.”
Ritter argues that an international portfolio should be biased towards Euroland bonds at the expense of US Treasuries which they recommend to be kept at no higher than neutral. Ritter adds a cautious note, however, suggesting that there may be some bad news on the fiscal front in Euroland. He goes on: “Nearly every country in Euroland wants to cut its budget deficit, but we do not think this will be happening. Look at Germany and France, both of which have elections coming in 2002. It is hard to believe that 2001 will turn out be a year of fiscal tightening.”
Cordius agrees that European bonds should offer better value than those in the US, if only because it believes the dollar’s period of strength against the European currency is over. “The US currency risks losing its essential advantages as the economy slowdown is confirmed, namely the higher rates, increasing productivity and FDI flows. In fact merger and acquisition activity has already fallen to less half of this year’s monthly average. We think that, in this climate, the market may finally turn towards economic fundamentals and reassess the risks of the clear over-valuation of the US dollar and the huge external deficit.”
In terms of curve trades, Cordius thinks the euro-government bond curve could be changing shape in the coming months. “Several Euro-zone states have recently announced their intention to issue securities with maturities of 10 years and longer.” Coupling this negative outlook for long-dated bonds with its fears for higher short-term rates than currently priced in, it believes that the safest place to be is in the middle – away from the shorts and the very longs.