The equity market’s loss is the bond market’s gain. Sharp falls on global equity markets have encouraged investors to re-appraise the outlook for volatility and look again at potentially defensive bolt-holes. Short-term investors may have been reducing equity positions and opting for cash as a temporary holding strategy and if equities rediscover their footing doubtless cash will be recommitted. Longer term investors have, in large part, opted to ride out the past week’s slide on the basis that it had been well flagged in advance and represents little more in a long overdue pause for breath before share prices resume their relentless rise. Given the apparent size of the private equity pot who is to say that recent weakness might not be used as an opportunity to launch a confidence boosting mega-bid? But something else is stirring; the bond market is waking up!
Bond markets: why investors are returning
One consequence of the recent bout of financial market volatility is that some investors have opted to look again at the, previously unloved, bond market. Whilst some might look back on the past week’s events and think that little has really changed to differentiate these events from those of May / June last year, in our view two very important things have changed. Firstly, the yen carry trade is under pressure, potentially removing a major source of additional liquidity from the market.
The second is that the US economy is now showing clear signs of slowing down whereas last year it was still growing strongly. Although underlying inflation is proving hard to eradicate, we suspect that as the year progresses it will ease back sufficiently to provide the Fed’s Open Markets Committee the confidence to begin the process of, possibly aggressive, monetary easing (probably from Q2 2007). The latter has significant, we think, potential implications for the outlook for the US Treasury Bond market. The yield curve has been steeply inverted for the past nine months, indicating that bond investors believe there to be a good chance of the US economy experiencing a hard landing, if not quite recession. A technical recession (two consecutive quarters of negative growth) is, however, possible if the Federal Reserve does not act swiftly and it is anticipation of such a move that the short end of the Treasury Bond yield curve has begun to move.
Bond market: Treasury yields set to fall
Irrespective of any near-term equity market revival, we think that short and medium dated US bond yields are likely to head lower over the remainder of 2007 and into 2008. A previously aggressive 4.5% target for 10 year Treasuries looks nothing like so aggressive now. Given our expectation that underlying inflationary pressure will ebb and that activity will emerge below trend (at best) we suspect that Treasury bond investors might take their cue and drive yields down, certainly to 4.25% and possibly 4.0% by year-end. This is an aggressive target; however, we suspect that the Fed will, when it starts to ease policy, chose to be equally aggressive. Base rate reductions to 4.5% by end-2007 seem a distinct possibility with the chance, although it is not our central projection, that rates might fall further in 2008.
The outlook for the US economy is likely to trough around mid-2007 by which time fears regarding the economic impact of last year’s slump in the residential property market should be fully apparent. Given our long-held belief that consumer spending and business investment are closely correlated, we suspect that the US corporate sector will still be signalling lower corporate earnings growth over the second half of this year. This should be sufficient to ensure that investors, exhausted by the ongoing revival in volatility, become increasingly committed to the US bond market. Note that risk premia have fallen to very low levels and last week’s equity market turmoil has done relatively little to reverse the situation so far.
Bond market: US bonds regain their appeal
It is not too difficult to construct a scenario in which US bonds come back into fashion as that economy slows to a sub-trend pace and where corporate earnings continue to disappoint. 10 year Treasury bond yields have the scope to break decisively below last year’s levels with a slide to 4.0% not to be ruled out, particularly if financial market activity were to become disorderly. This may seem a far cry given that relative tranquillity appears to have been restored but given the speed with which financial market storms can brew up we regard as a distinct possibility the likelihood that US Treasuries could regain their appeal.
By Jeremy Batstone, Director of Private Client Research at Charles Stanley