The expansionary monetary policy that the Fed and the ECB will likely continue to pursue going forward, the steep yield curve and the weak US Dollar should be taken into due consideration when evaluating the outlook for the European and US bond markets. The first two show that both countries enjoy a similar scenario: yields should be little changed for several months and then experience a flattening of the curve, the scope of which will depend on inflation. Due to the strength of the Euro against the US Dollar, investors should not invest in the U.S. bond market until the dollar’s negative trend reverses.
The prospects for the European bond market appear to be rosier. Given that interest rates will likely rise slightly and gradually, we recommend overweighting the short and medium end of the curve in the Euro area. By contrast, the long end of the curve would face greater risks should inflationary pressures mount. Only a deflationary scenario, which is highly unlikely to materialize for the time being, would suggest investing on the long end of the curve. In the medium term, higher gold prices and the rise in the expected future inflation rate as implied by the TIPs show that the market is beginning to fear a pick-up in inflation in the months to come. Reducing the duration of portfolio securities to focus on Euro-denominated medium-term stocks (3-5Y), seems to be a viable solution.
Emerging markets Government bonds are likely to perform in line with major international stock markets. Indeed, the former have largely benefited from a lower financial risk premium and expectations that the worst for the global economy may be behind. With U.S. government bond yields unlikely to rise sharply in the near term, the uptrend shown by emerging market government bonds would come to an end should financial market tensions resurface and the global economic upturn prove short-lived.
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