International financial markets have endured intense volatility over the last few weeks. Indeed, leading international equity indices have continued to follow the upward trend began in March, with the Dow Jones Industrial back above the 10,000 level for the first time since October 2008. Even currency markets have seen a lot of action, with the Euro moving back past the 1.49 mark against the US Dollar - a level last seen in August 2008. But the financial market excitement has not spread to major international bond markets, which appear to be going through a phase of apparent calm notwithstanding the recent signs of economic improvement. Accordingly, Central Banks will likely implement an exit strategy beginning in mid-2010.
Yields on the short and long end of the curve have been relatively unchanged both in the US and in the Euro area over the past few weeks. In the US, the 10-year Government bond yield remained below 3.5%, while the 2-year note yield continued to hover around the 1% level.
The bond market has been substantially quiet this week notwithstanding the dollar’s fall against major international currencies and the jump in gold prices to the historical high of US$1066oz. This is clear evidence that bond investors do not fear a dangerous increase in inflation, as the uptrend in gold prices and the US Dollar might indicate. Indeed, inflation expectations for the years ahead have been moderate, as the trend followed by the inflation-indexed securities (Tips) has shown. The implicit inflation estimate for 10-year Tips stands at 1.8%, well below the 2.2% historical average. With a real rate of 1.5%, the Tips also indicate that the market does not expect the U.S. economy to make a comeback to robust growth in the coming years, contrary to what the recent equity market rebound would suggest.
Restrained inflation and economic growth expectations for the years to come are a source of considerable concern for U.S. Government bonds going forward. In fact, should inflationary pressure increase or economic growth be stronger than expected, Treasury yields would rise sharply and lead to capital losses. Moreover, for non-US investors, the US Dollar trend is another risk factor for the U.S. bond market. A continuation of the US currency downtrend, in fact, would ensure that the returns yielded by the coupons would not be able to offset the accumulated currency translation losses.
As things stand, we do not recommend investing on U.S. Treasuries but awaiting a trend reversal in the US dollar, which is undervalued against all major international currencies according to OECD statistics on Purchasing Power Parities (PPP) as we have indicated here and here. In so doing, considering also that there is much likelihood that the Fed will embark on monetary tightening in 2010, investments should be first channelled toward the very short end of the curve, which is less subject to capital depreciation when interest rates increase. Investments would subsequently shift toward the long end of the curve should inflationary pressures be contained. The table below shows that a sharp steepening of the yield curve (the spread between the 3-month T-Bill and the 10-year T-Bond is about 330 bps) has historically been followed by a rise in short-term yields and a fall in long-term yields. Although a sharp decline in 10-year yields in the face of an economic recovery does not seem to be on the cards now, yields may return to fall after an initial rebound as investors start discounting an economic slowdown.
The European bond market outlook looks rosier, particularly due to the single currency strength against the greenback. Indeed, inflation in the Euro area would remain more moderate than in the U.S. should the international economy recovery heighten inflationary pressures, hence delaying and limiting a monetary tightening by the ECB.
Indeed, even a possible reversal of the Euro’s uptrend will likely have a limited impact on the near-term inflation and monetary policy prospects. Based on a study by some OECD economists ("Standard shocks in the OECD Interlink model" by Dalsgaard, André and Richardson), a 10% decline in the Euro would push up inflation by 0.4% in each of the following two years - not particularly worrying given the now restrained inflationary pressures. A reverse scenario, i.e. the emergence of deflationary pressures should leading international economies fail to pull themselves out of the crisis, would enable the bond market to post positive performances.
As the ECB is likely to raise rates in small and not too frequent steps, short and medium term bonds are to overweight in a bond portfolio. Indeed, long term bonds would face greater risks in the face of heightened inflationary pressures. Only a deflationary scenario, which is highly unlikely to materialise any time soon, would lead investors to invest on the long end of the curve.