Recent market developments Despite the continuing stream of good economic news, yields have continued to fall in the past month. There are three main reasons:
- 1. Central bank rhetoric remains very soft, and certainly does not signal imminent interest rate hikes at the moment.
- 2. It is the “wrong” economic data that are surprising. Many still have the opinion that the current economic recovery will not lead to a sustained upswing – and as long as there is no decent growth in US jobs and consumption there will be grounds for doubt.
- 3. Speculating in higher yields is a very expensive bet due to the steep yield curve. The large gap between funding costs and the yield one obtains on the bond makes it – all else equal – attractive to speculate in lower rates.
This has led to expectations of rate hikes in the next couple of years being toned down, yields falling and yield curves steepening on both sides of the Atlantic.
Macro outlook
The US economy has seemingly left its recession behind, and indeed a string of key indicators are recovering rapidly. There are currently two major unresolved issues: Is the current recovery strong enough to turn the labour market around and set in motion a posi-tive dynamic whereby job growth spurs private consumption, which in turn creates more jobs, and so on? And secondly, will the US savings ratio climb further?
We expect that the current upswing will soon translate into employment growth, meaning that unemployment will turn in 2010. Meanwhile, our view is that renewed wealth growth and the already significant correction in the savings ratio will result in the savings ratio not increasing further going forward but, on the contrary, falling a little. We thus expect to see a relatively strong upswing in the USA in the coming quarters.
Euroland has also pulled out of recession. A combination of a major production backlog and the turnaround in the global industrial cycle is helping exports and at the same time boosting investment. Solid growth in the USA and Asia will benefit Euroland in the com-ing quarters.
Inflation is not a problem in either Euroland or the USA. Low capacity utilisation and slowing wage growth mean the outlook is for falling core inflation in the coming quarters. Headline inflation will increase as a result of higher commodity prices, but it will remain modest in both the USA and Euroland.
Central banks and bond yields
The Federal Reserve is done with easing monetary policy, and the focus now is on exit strategies from the alternative monetary policy measures. Some measures will simply cease, such as the buying up of Treasuries, which will stop at the end of October.
The Fed is expected to keeps its key interest rate at 0-0.25% for a long time. Inflation is low, and there is abundant spare capacity in the economy, meaning the need for higher monetary policy rates is not just around the corner.
Further economic growth, the massive supply of Treasuries, the Fed halting its buying up of Treasuries and increased risk appetite are expected to lead to significantly higher yields in the coming quarters.
The ECB is expected to hike interest rates next summer, when the upswing has taken a firm hold and the labour market has clearly turned. The ECB is focused on money supply and credit growth, and by next summer the growth in money supply will been growing briskly for quite some time. Besides, the key rate in Euroland is at a historic low. The ECB fears new bubbles, and it has learnt its lesson.
We expect European yields to rise in the coming year as the economic outlook brightens and interest rate hikes move closer. There is also considerable issuance pressure from government bonds in Euroland.
