The 2011 bond market has started strongly in terms of new corporate issues with a quick take-up by investors. However, the explanation may lie more in faute de mieux (absence of attractive alternatives) than in inherent value. We rather suspect the same applies to stock markets while interest rates remain so low.
Will they remain this low? That is a fundamental question for fixed-income investors. The question needs addressing in terms of overnight rates as controlled by central banks and the steepness of the yield curves as controlled by markets. The latter is easier to answer. Steepening looks inevitable in most major currencies for two basic reasons:
The outlook in the USA is complicated by the practice of quantitative easing, whereby Fed acquisition of longer-term Treasuries should help demand for government bonds match the higher supply (although this has worked less well than the Fed surely expected).
The outlook for overnight rates is partly a function of the different remits of each central bank. Of the four central banks with which we are most concerned, the Fed has a sharp difference from the others in being responsible both for controlling inflation and also for maintaining employment. Unemployment in the USA is stubbornly high and any pretense of the Fed being concerned about the dollars exchange rate has disappeared. In fact, the US authorities in general are unaware or do not care that a weaker currency leads to imported inflation.
In both the UK and the Euro zone, inflation has risen over the target ceiling rate of 2%, especially in the UK. Since the remit of the ECB and the BoE is to restrain inflation independently of political influence, all logic says that a rise in rates is likely in 2011, led by the BoE.
In Switzerland, the problem is quite the opposite. Inflation is very low (under 1%), due not least to the extremely strong CHF. Raising rates is therefore very unlikely, as to encourage still greater flows into the CHF is the last thing the SNB wants.
If the above reasoning is sound, the BoE will lead the way in raising rates, then the ECB, with the Fed well behind and the SNB last. The implications on average maturities are clear: short maturities for GBP and EUR.
We have often referred to the great experiment of comparing the US approach of continued stimulus and the European approach of relative austerity to deal with the aftermath of the recession. We have suggested that one explanation is the political inacceptability in the USA of lowering living standards by matching expenditure to means. There may be, however, an additional and complementary reason to explain the sharp difference between the US and the European approaches. In the USA the general perception is that the recession is purely cyclical and that the old remedies of stimulus and loose money are quite adequate to push the cycle along to its expansionary phase. Superficial evidence, notable official GDP growth, supports this perception. However, we believe it to be quite wrong and that the USA is at or very near the end of the road where it can live beyond its means and pay for an excessive share of the worlds production with bits of green paper.
We go further. The days of the hegemony of the USD as the reserve currency are coming to an end. The rise of Asia and world GDP rebalancing render obsolete the concept of a single national currency for monetary reserves and international trade. Some suggest a return to the gold standard, but that does seem a retrograde step for international trade because the supply is limited. The emergence of a new reserve currency, probably based on some mix of various monies and precious metals, will be a fascinating tale as 2011 unfolds.
January 5th 2011
Dr. Roy Damary