Faster and more synchronised world growth is bad news for bond markets. But the prospect of accelerating growth in Europe and a slowing US economy next year points to the outperformance of US bonds vis-à-vis the EU.
Current yields make US treasuries look more attractive than those in Europe or Japan - especially at the two-year to five-year maturities. US 10-year yields may spike up over the next two or three months in anticipation of further interest rate hikes by the Federal Reserve. Thereafter, however, treasuries will rally - the supply of federal debt is set to decline sharply over the next three years as the US heads for sustained budget surpluses.
One way or another, US growth is set to slow - in direct contrast to the European economy. Most likely, it will be a pretty hard landing in which the Fed raises rates by another 75 to 100 basis points to curb excess demand. The negative wealth effect of a big equity market correction would then slow the economy rapidly over the next year. If that's right, US treasury yields will spike higher in the short term.
But I think that would provide a significant buying opportunity for US bonds. For there are some key factors that make US treasuries look very attractive in the longer term.
One reason is structural. The supply of US treasuries is set to collapse over the next few years. Sure, the projected 2% to 3% of GDP US budget surpluses are unlikely to materialize - tax cuts or extra social spending win more votes. But even a 1% of GDP budget surplus sustained for the next few years, accompanied by 2.5% average real GDP growth, would halve the stock of treasuries.
In contrast, Europe's public finances are not likely to improve much over the next five years, and could even worsen. For let there be no illusions about Europe's public sector. Little has changed there. Europe's governments managed to get their budget deficits within the Maastricht treaty target of 3% of GDP almost totally because interest rates fell. In 1997, euroland's average government budget deficit was 2.5%. In this year of the euro's birth, that average has fallen to 1.8% of GDP. But the euro governments' average primary surplus (excluding interest costs) is virtually unchanged at 2.6%.
The European Commission expects euro-area government deficits to fall to 0.8% of GDP by end-2002. But of that one point fall, half is supposed to come from lower interest payments, 20% from faster growth and only 30% from further structural reform in public finances. So if interest rates are higher, not lower, five years hence, EC president Romano Prodi's forecasts of lower public debt and deficits will turn into its nightmarish opposite.
Even more significant: two currency blocs will emerge over the next three to five years - one focusing Latin American states around the dollar; the other focusing emerging European countries on the euro bloc.
However, the impact of EU enlargement on the credit quality of European bonds is much more negative than the equivalent impact of Latin American dollarization on US treasuries. After all, enlargement of the EU involves significant economic, fiscal and even political integration. There's no hint of such a move in the Americas. All this supports the idea that over the next few years, US treasuries will outperform all other major bond markets.
And then politics in the core of Europe is beginning to look sicker. In recent weeks the ruling Social Democrats (SPD) in Germany have suffered humiliating defeats in state and municipal elections. So any hopes of winning back a working majority in the Bundesrat (Germany's upper house) - which is critical in approving key legislation - have been dashed. Many of the reforms that chancellor Gerhard Schröder had hoped to push through parliament will now be subject to compromise and dilution.
That need not be terminal for much of German finance minister Hans Eichel's recent DM30 billion ($16.4 billion) savings package. The opposition Christian Democrats agree with much of it. But it means that there will have to be more give-and-take over controversial bills - in particular covering such issues as tax and pension reform. And these are precisely the reforms Germany needs to enact quickly.
Only a strong economic upswing can restore the SPD-Green government's popularity. There are tentative signs that just such an upswing is materializing. If the recovery blossoms and quickly brings down unemployment, chancellor Schröder may yet avoid the ignominious fate of chancellor Helmut Kohl's last two years in office. Without it, Schröder is set to become a lame-duck premier.
If it were not for the apparent economic upswing, I'd be more bearish about German financial assets. As it is, 3%-plus real GDP growth over the next year - led by the consumer - looks on the cards. That should support equities and the euro. But heightened political uncertainty - along with accelerating economic growth - will undermine German Bunds.
David Roche is president of Independent Strategy, a research firm based in London. www.instrategy.com