Fixed interest markets globally have had a phenomenal run over the past 20 years. In the US, yields on longer dated government bonds have fallen from 14 per cent in 1981 to as low as 3 per cent in June 2003. In Australia, the equivalent moves were from 16 per cent to 4.5 per cent. The key driver: the sharp fall in inflation worldwide, culminating in the deflationary scare of 2003.
In judging the way forward, there are two perspectives that need to be taken into account, the structural (longer term) and the cyclical (shorter term). In terms of the former, the key question is “what type of inflation environment are we in?”
Inflation globally over the next decade is likely to be relatively stable within a narrow range of around 1.5 to 2.5 per cent. In this climate, long term government bond yields generally are likely to move in a sideways pattern between around 3 and 6 per cent, a much tighter range than seen in the inflationary 60s and 70s and the disinflationary 80s and 90s.
In short, we do not see a strong directional trend to bond yields structurally with the exception of Japan, where 10 year yields of 1.2 per cent are, in our opinion, unsustainably low as the country gradually exits its long period of deflation. In a global mandate, Japan should be underweight from a structural perspective.
In terms of the cyclical (shorter term) outlook, longer term government bond yields have risen by around 1 per cent from their 2003 lows, to 4.1 per cent in the US and 5.6 per cent domestically. Further rises are likely as economic activity worldwide continues to increase and the US Federal Reserve gradually raises short term interest rates to more normal levels. With US bonds currently benefiting from so called “carry” trades ie. investors borrowing at 1 per cent to invest in 10 year securities yielding 4 per cent, the reaction to the initial move in short rates may be both swift and sharp. Nevertheless, we do not foresee a major bear market ahead. The foundations to the global recovery are atypical, with a world too reliant on an over indebted US economy.
Sustaining the pace of the recovery is likely to prove more difficult as we move into 2005, a fact unlikely to be lost on central banks in their conduct of interest rate policy. Together with a favourable outlook for inflation, this means 10 year government bond yields should be contained below 5 per cent in the US and 6 per cent in Australia, where any further 0.25 per cent rise in short rates may well be the final move in this cycle. The major risk to this relatively benign view on the outlook for bonds is a withdrawal of support by the Asian governments, who have been large buyers of US fixed income securities with the foreign exchange they have accumulated in selling their currencies to preserve their competitiveness. Such a risk cannot be dismissed, but on present indications seems unlikely to materialise in 2004.
While improving economic activity will enhance the interest paying capabilities of such borrowers, it is nevertheless the case that spreads are now approaching historical lows. Investors should be careful in making further commitments to this segment of the market, particularly in lower quality credits, where any concerns over the durability of the global economic recovery would see spreads widen quite quickly.
— Paul Laband is director of Asset Consulting with Towers Perrin
