The trend for European bonds to fall has continued in anticipation of interest rate rises in the Euro-zone in the fourth quarter and beyond.
German 10-year bund yields rose above 5% as investors became nervous of the pace of recovery in core Europe.
Expectations of a rise in interest rates by the European Central Bank have been dampened, in the short term, by an absence of hard evidence on the strength of the growth trend in Europe. The markets seemed anxious for the ECB to assert itself but economic forecasters suggested the ECB would not be swayed by marginal growth trends. And as it turned out, the ECB elected to leave its key interest rate unchanged at 2.5% in the third week of October, which has left the markets expecting that it will raise rates at its next meeting of 4 November.
Inflation did not move from the annualised 1.2%, growing pressures from rising commodity prices and wage settlements are putting upward pressure on prices. The picture of benign inflation in France and Germany, which account for around half the Euro-zone economy, continues to be matched by rising inflation in peripheral countries such as Spain and Ireland.
Although German business forecasts were less promising than expected, the momentum of sentiment behind the German recovery may be sufficient for the ECB to raise rates before year-end to quell inflation.
But the ECB’s caution is matched by a lack of consensus on the growth trend. Investec Guinness Flight’s European bond manager Paul Brain comments: “Although the recent rise in commodity prices and the weakness of the euro since its inception will nudge up inflation, the Euro-zone economy is still some way from overheating. “For this reason, I believe that the ECB will wait until early 2000 before raising interest rates.”
The IGF European Bond fund’s duration has been short of the benchmark in reflection of the manager’s forecast of rising yields in Europe and the rest of the world. The bond market is likely to remain nervous ahead of the next rises in interest rates but yields have largely discounted future monetary tightening and this represents a good opportunity to buy European bonds, in anticipation of lower yields in 2000.
For all this, sentiment on the bond markets in the run up to the end of the year will be governed as much by expected volatility of world stock markets as much as by concerns about inflation. Lower share prices will only be supportive for treasuries if declines are substantial.