Global: The Party's Over
Joachim Fels (London)
Bear market in bonds… The bear market in bonds is now a little more than a month old. It all started with a shockingly large increase in US January core producer prices and Federal Reserve Chairman Greenspan’s “conundrum” comments (please see my piece entitled “The End of the Bond Rally” in Alpha Strategies, 23 February 2005). Since then, US 10-year Treasury yields have backed up by more than 60 basis points, to 4.62% at the time of writing, driven largely by an upward revision in investors’ inflation expectations and, most recently, a more hawkish Fed statement following the 22 March Federal Open Market Committee meeting. I continue to think this bear market in bonds has much farther to go, and I see yields breaking through the 5% level eventually.
… has reached risk assets. In the initial phase of the bond sell-off in late February and early March, the riskier fixed income assets such as corporate bonds and emerging markets continued to outperform. But that’s over now. Risk spreads have widened out, both in corporate land and in emerging markets, with the General Motors profit warning last week serving as the trigger for the risk-reduction trade. Investors’ appetite for risk, which had been huge, appears to be on the wane. We are now witnessing the spreading of the bear market in government bonds to riskier fixed income assets, which have started to underperform. As I see it, this is the beginning of a major bear market in virtually all fixed income assets.
Of course, this bear market will not proceed in a straight line. There are still many investors who see the glass as half-full rather than half-empty. They argue that what we are seeing right now is merely a healthy correction of previous excesses and that the fundamentals are still good: The world economy is growing strongly, GM’s plight is an isolated event, and inflation will remain well-behaved, or so the story goes. Thus, many investors who missed the previous rally may see a sell-off as a buying opportunity, which could spark occasional rallies.
Sell on rallies. By contrast, I think the glass is not half-full but half-empty, and I would use occasional rallies to sell. In my view, the recent sell-off in fixed income is the beginning of something larger: Rising risk aversion should lead to a further unwinding of speculative positions, and, most importantly, economic fundamentals, which have been largely favourable so far, should deteriorate markedly in the course of this year.
The core of my bearish view is stagflation. As I have explained before, I think strong global growth will give way to relative economic stagnation. And I believe that US inflation is headed significantly higher. Stagflation results from super-expansionary demand policies, on the one hand, and negative supply shocks, on the other, and what I have in mind here is negative shocks from rising commodity prices and from slowing productivity -- exactly what we are experiencing at this moment. Stagflation is bad for most asset classes, and deteriorating fundamentals and falling asset prices should mutually reinforce themselves. So, the virtuous cycle of improving economic fundamentals and rallying markets could turn into a vicious cycle, in my view.
But excess liquidity should be a mitigating factor. I look for a continuing rise in bonds yields and also a widening of risk spreads over the balance of this year. I’m not mega-bearish, though, because I think there is one important mitigating factor: excess liquidity. If I’m right on stagflation, then central banks, led by the Fed, will probably abandon their tightening campaign later this year. This would keep liquidity abundant and should eventually contain the damage to financial markets. But, again, a precondition for a change in the Fed’s policy stance is a significant slowdown in US economic growth, which has remained elusive so far.
Europe: outperformance in the bear market. European fixed income markets have been unable to decouple from the US bear market, but yields have risen less strongly than they have across the big pond. In line with expectations, the transatlantic government bond yield spread has widened further, approaching our target of 100 bp in the ten-year sector. In my view, there is room for an even larger widening. While economic growth in the euro area probably rebounded in Q1, the signals from the forward looking indicators such as the March Ifo survey point to a renewed slowing in 2Q. The rise in oil prices is likely to weigh on consumer spending, and the momentum from export growth appears to be waning. Moreover, the inflation fundamentals in Europe are the mirror image of those in the US: Unit labour cost growth in Europe is decelerating, and the past euro appreciation is still working its way through to consumer prices.
Enter the ECB? Against this backdrop, the European Central Bank still looks unlikely to rush into a rate hike anytime soon, despite the relatively hawkish recent rhetoric. Yes, excess liquidity, asset price inflation, and the return of virtually uninhibited fiscal policy discretion through the so-called reform of the Stability and Growth Pact are worrying euro area policymakers. (As an aside, they also worry me a lot, which is why I will again vote for a 25 bp rate hike in the forthcoming ECB Shadow Council meeting.). However, I continue to think that the ECB will want to see a return of economic growth to around its trend pace in both 1Q and 2Q before addressing these issues. With the clouds over 2Q growth building up, excess liquidity is here to stay for quite a while longer. Thus, European bonds look likely to continue to outperform US bonds. |
