• Optimism. The latest economic surveys in the US paint an, in general, optimistic picture. Manufacturing and business investment point north. Private consumption continues to post respectable growth, albeit not as dynamic as at the beginning of the year.
  • Surprise. The weakness in the US housing sector will presumably continue to crimp growth up to the end of the year, but there could be a real positive surprise in the current quarter. Both construction-related output and sales have recently staged a marked recovery, at least temporarily (page 4-6).
  • Pressure. Even though there are still downside risks in the housing sector, the worst of the economic slowdown is probably now behind us. Taken in conjunction with the continuing strength on the labor market, the Fed is becoming increasingly concerned about inflation. Above all the renewed sharp rise in energy prices has seen a strong increase in inflationary pressure recently (page 7-8).
  • Bottleneck. Inflation is also causing problems for the Bank of England. The core rate has accelerated appreciably. And the growing capacity bottlenecks suggest that there will be no relief any time soon. For that reason, a further rate hike to 5.75% appears to be a done deal. And the odds on 6% have risen (page 14-16).

Further topics:
– Weekly Comment: Bond markets: Back to the old world order? (page 2).
– EMU: Financing conditions remain favorable (page 9).
– Italy: GDP forecast for 2007 revised up (page 11).
– Sweden: Riksbank to tighten further (page 17).
– Data outlook: US construction data mixed; German business climate robust
(page 20).
– Market outlook: Bond market and EUR/USD correction likely (page 25).

Bond Markets: Back to the Old World Order?

Financial markets have undergone quite a serious shock in the last ten days. On Thursday June 7, yields on 10Y Treasury bonds suddenly broke through the 5.0% level and stock markets sold off.
This has been followed by a few days of very volatile action in markets, with yields on 10Y USTs pushing above 5.30% on June 12-13, before consolidating at about 5.22%. The level of 5.30% is of high psychological significance, because it is comfortably above the peak reached almost exactly a year ago on the back of inflation fears. That had been the highest level since 2002. In other words, it had been the highest level since we entered the brave new world of very low bond yields and flat or inverted yield curves.
The immediate trigger of this market movement seems to have been a sudden change of heart in the markets regarding the prospects for US growth. Most of the global investment banks which were still forecasting Fed rate cuts in 2007 suddenly capitulated, as accumulating evidence persuaded them that the US economy has probably bottomed out in Q1 and will recover thereafter. Fed rate cuts were quickly priced out of the futures market. We had been well ahead of the curve in our Fed forecasts, but still we were surprised by the speed and magnitude of the market’s reaction as bond yields in the US climbed sharply, in turn pushing the 10Y Bund yield above 4.60% by last Tuesday.
What will happen next? Uncertainty is now extremely high, and attention is focused on US consumer inflation data which will be released just after this publication is released. At this stage, I believe what we have seen so far is an overreaction. I do see the risk that in the short term we might witness a further bond sell-off, with yields on 10Y USTs moving towards 5.50% and 10Y Bund yields pushing to 4.75%. In the coming months, however, I expect bond yields to come back down, to end the year around current levels for Bunds and somewhat below current levels for US Treasuries. But as I said, uncertainty is extremely high, and I think it might be useful to keep in mind the following considerations. The market has suddenly accepted that the Fed does not have an easing bias and is not likely to cut rates.
The Fed has been stressing for some time that it is concerned about upside inflation risks while it sees risks to growth as symmetrical. I believe, however, that the market has swung too far and does not price in at all the risk of renewed weakness in the US economy. We have never believed that the housing market adjustment would cause consumption and GDP growth to collapse. But we still believe it will take more time for the adjustment to run its course.
The Fed has also warned that the housing adjustment will continue to affect the economy for at least the remainder of this year. And certainly, if long term yields remain at current levels or climb higher, the resetting shock that many adjustable-rate mortgages will go through over the next 12 months will be even more dramatic. Overall, I think there is a clear risk that mixed economic data will in the coming months shake the market’s new-found confidence in US growth.
The recent rise in yields seems to reflect largely growth optimism and not inflation pessimism. Inflation expectations as derived from example from TIPS in the US have not moved significantly. Moreover, the steepening of yield curves indicates that shortend yields have remained well-anchored.
There has not been a significant rise in risk aversion. Risky assets have in general held up fairly well, and the trend of JPY and CHF shows that carry trades have also largely been kept in place. This probably makes sense, given that higher confidence in US and global growth, combined with still high liquidity, provides a still favorable backdrop for risky assets.
There is concern that the sell-off in US Treasuries might also reflect weakening demand, particularly from official buyers such as Asian central banks. This reflects the current debate on the role of Sovereign Wealth Funds, which might divert investments on newly accumulated foreign exchange reserves from safe assets such as USTs into more highyielding assets. I believe this phenomenon will only play out gradually, but again it should provide additional support to risky assets.
We have seen a weakening in demand for US bonds, but not for USD. In fact, the USD has strengthened significantly, suggesting that those investors who have taken money out from the US bond market or from other assets have correspondingly increased their holdings of dollar cash. This would suggest that the weakening in demand for USTs has little to do with concerns about global macro imbalances and the prospects for the USD.
curves with a short-end anchored not too far from the monetary policy rate. The onset of the new world order of flat or inverted yield curves had taken most people by surprise, and one can therefore not rule out the possibility that we might now be witnessing the undoing of that shift. I am somewhat skeptical, however. Liquidity is still ample, and the technical factors that have driven an increase in the demand for long-term bonds seem to be still in place.
Indeed, we have already seen signs of resurfacing interest in USTs and Bunds, which at these higher yield levels appear significantly more attractive— although most investors are still wary of the volatile short-term dynamics.
We might, however, be witnessing the very first effects of a draining of liquidity finally brought about by the monetary policy tightening which major central banks started a fairly long time ago. Even in that case, however, I would expect the effects to be more gradual and would regard the recent movement as a likely overshooting.
The recent market turbulence might open up some interesting investment opportunities. Uncertainty however is extremely high, and we do not fully understand what is going on at the moment. We will be revising our recommendations on global asset allocations in the next few days, after the US inflation releases and the market's reaction to them—watch out for our Cross-Asset Navigator to be published next week.