Bond Outlook November 2nd

How the world has moved on from just a couple of months ago when Asian Central Banks were sustaining the dollar and keeping the yield on the 10 year US bond down. They have now reduced their purchasing, not so much because they have a sudden aversion to the dollar, but because private flows into US bonds of all types are attractive at the higher yields. Manufacturing is proving a lot more resilient in the USA, the UK and the euro zone. Inflation is now assumed to be a serious threat because of high oil prices, which, even if they are off their peaks, are bound to wash through to other goods and services.

Interest rates are on the rise, led by the Fed, which obviously has no intention of stopping at 4%. Our recommendation of focusing in USD on index and inflation linked instruments is a means to defend fixed-interest investors against rising yields across the curve. What now, however, is going to happen in the euro zone? Two scenarios can be envisaged, both involving flattening, but of two different types, once the ECB starts lifting the refi rate:

• That the EUR yield curve will echo the development of the USD curve, with the short end rising and the long end remaining low
• That the EUR yield curve will rise across the board, albeit with the long end moving up more slowly than the short end

As of today, we lean towards the second scenario on the grounds mainly that the ECB never went the route of cheap money taken by the Fed, and also that inflationary pressures today are more severe than when the Fed started raising its rate.