This year appears to be starting well, for the US and European economies at least. On both sides of the Atlantic, forecasters have been upgrading their figures as new data emerges showing surprising economic strength: the recent German Ifo and French INSEE surveys, US consumer sentiment, US GDP and Chicago PMI. But bond markets stood still or perhaps, in spite of this flow of potentially interest rate negative news, ticked up a bit.
“The last months of last year were disappointing for bond investors. The market was quick to adopt the recovery theme which led to higher yields across the curve(s),” says Robeco’s Roeland Moraal. “Our market view now is that, on a fundamental basis, we expect bond markets to resume their rally in the medium term. We see inflationary pressures declining rapidly and this in itself is supportive for lower yields.
“At last after 19 months, inflation within the Eurozone has reached the ECB’s 2% inflation target. In December CPI fell to 2% from 2.1% in November, which was the seventh successive fall from the May peak of 3.4%. We believe that headline inflation can drop to 1–1.5% in six months’ time. The decline in commodity prices has been one of the major drivers behind this decline, but we believe that the outlook continues to be favourable and that excess capacity will dampen price pressures further.”
For other investors, the threat of inflation is more real. “We are certainly bearish about inflation in Europe,” says Bank Austria’s Andreas Schuster. “We think that there has been an underlying deterioration in the inflationary picture and believe that the fall in the headline rate over the past six months has been largely due to the positive effect from falling oil and commodity prices.” Schuster comments that the ECB’s inflation target does not have that much significance – a view which he suggests the ECB shares – and that the monetary policy decisions have not really been correlated to the inflation trends.
Schuster believes that there has been a fundamental shift in the behaviour of inflation. “Generally, over the last 10 years the textbook relationship between a strong economy and increasing inflationary pressures has been turned upside down. Now we have been having falling inflation even in the good economic times. I cannot explain it in terms of fundamentals. I can only look at the trends and see them in black and white. So, now that we have been having a weakening economy, inflation will react by ticking up. However, if we are right in agreeing with the consensus view that we will have a stronger economy in 2002 then inflation will fall again.”
Schuster suggests that the ECB will be concerned about the inflation outlook, particularly in Germany and thinks there is an outside chance of one more quarter-point cut, but more likely it will sit back and watch the situation.
But Robeco’s Moraal is not convinced. “January inflation picked up to 2.5% for the Euro-zone as a whole and this was not anticipated at the end of last year. However, reasons behind the jump relate to rising food prices, indirect tax hikes and the changeover to the euro. We believe the ECB is right (for once) to say that this hiccup in inflation will prove temporary and price pressures will decline substantially in the course of the coming months. Given the ECB’s mandate to focus mainly on the inflation outlook, we believe that the Central Bank will lower rates further. Money market futures contracts now discount no more rate cuts, and thereafter 50–75 basis points of monetary tightening is priced in until the end of 2002. Here we disagree and we will continue to hold our long position in the euro money market curve.”
He goes on to argue that sharp declines in producer and import prices will filter through to the CPI figures, and that excess capacity in many industrial sectors will provide a cushion for any pick-up in demand. He also makes the point that the US GDP report indicates negative nominal GDP growth and asks, “When did we last see a negative price deflator? Back in the 1950s?.” He does strike a note of caution for this bright inflation outlook in Europe, pointing to wage negotiations in Germany. “The labour unions will try to use the January inflation figures to support their demands for higher wages. However, we feel that the worrisome condition of the German labour market should make it less likely that excessive wage rises will be agreed upon.
“We are positive on the US and EMU bond market. They have adjusted to the better economic outlook, but have not yet adjusted to the lower inflation story. The vigorous recovery theme has now become consensus and strong economic data has a much smaller effect. We believe though, that the recovery will be a slow one and not the one that has been priced in a short time frame late last year. Besides that we believe that the ‘extremely low’ inflation theme will start to have more impact. Sentiment has clearly improved and the technical picture of, for instance, the US 10-year bond yield bears witness to this.”
For Santiago Rubio de Casas, head of fixed income at Santander Central Hispano, the outlook for interest rates in Europe appears to be quite mixed and suggests the short term might be “safer” for bond markets than the longer term. “Our view is that we could have stable to lower short-term interest rates and rising long-term rates in the first half of the year. We think that by the end of the year the markets might be worrying about increasing government bond issuance.”
Whilst not agreeing with the Robeco team’s optimistic inflation outlook, Schuster and his colleagues do agree that now is not a good time to be taking big bets on the bond markets. “Our European portfolios are overall short duration right now, and we are positioned for some curve flattening. We see the 10-year rising to maybe 5.2% or 5.3%, but we are especially bearish of the two-year and think the two- to 10-year spread could narrow from around 100bps today to around 60.”
So it seems that market participants are still at odds over which direction interest rates will trend this year. If Schuster at Bank Austria is right about the relationship between economic activity and inflation being turned on its head, it could turn out to be another challenging year for even experienced bond investors.