Global: Dr. Jekyll and Mr. Bond

Joachim Fels | London

Jekyll and Hyde Following the ‘conundrum’ of low long-term yields during 2005 despite rising US short rates, global bond markets staged a (reverse) ‘Jekyll and Hyde’ performance during 2006, pretty much as I envisaged in my 2006 outlook piece a year ago (The Passing of the Batons, 8 December 2005). A sell-off during the first half of the year gave way to a powerful bond rally during the second half when the Fed paused and the signs for an economic slowdown in the US started to accumulate. As a consequence, the US 10-year Treasury yield now trades around 4.5%, only slightly higher than a year ago, but some 80 basis points below the peak of mid-2006. However, gazing into my crystal ball, I visualize a bearish scenario for the G3 bond markets in 2007, with yields moving back to, and possibly above, the temporary highs of last summer.

Three main drivers. In thinking about bond markets, I continue to focus on what I consider the three main medium-term drivers of yields: (1) the economic cycle and (2) inflation expectations, which together shape expectations of future central bank policy rates; as well as (3) the global liquidity cycle, which I suspect has been a key factor influencing the recently vanishing ‘term premium’ in bond yields (see also M. Pradhan, The Term Premium: A Puzzle Inside a Riddle Wrapped in an Enigma, in this issue). Here are my assumptions and expectations for how each of these drivers will develop in 2007.

A global mid-cycle slowdown, but no recession. I assume that the global economy entered a mid-cycle slowdown during the second half of this year that will become more apparent during the first half of 2007. While this is qualitatively consistent with our global economic team’s forecast of a slowdown in global GDP growth from 5.0% this year to 4.3% (see Stephen Roach’s Global Transitions for details), I agree with Steve that the risks to this number are on the downside. Importantly, however, I assume that the slowdown won’t lead into recession, but will give way to a second leg of this expansion, albeit milder than the first leg in recent years, starting some time during the second half of 2007. A crucial assumption here is that the US slowdown remains temporary and largely bottled up in the housing sector, as our US economics team expects (see Richard Berner and David Greenlaw. It’s a Growth Recession, Not a Lasting Downturn, 11 December 2006). If so, at some stage next year, investors will likely revise significantly upwards their expectations for the path of the Fed funds rate in 2008 and beyond.

… with Europe disappointing and Japan surprising. Looking elsewhere, I envisage the euro economy disappointing the upbeat consensus expectations, but Japanese growth surprising on the upside in 2007. Japanese monetary policy is still very accommodative and the yen is super-competitive. Meanwhile, even though there may be a nascent pick-up in potential output growth in the euro area reflecting past corporate restructuring efforts and labour market reforms, cyclical growth is likely to be hit by the removal of monetary stimulus over the past year, fiscal tightening in Germany and Italy, and the trade-weighted appreciation of the euro. As a consequence, while I’m outright bearish on all the G3 bond markets, I do expect euro area bonds to outperform US Treasuries and JGBs in the sell-off, reversing their underperformance of the last six months or so.

Sticky inflation. While my view that this is a mid-cycle slowdown (though possibly a sharp one) rather than the onset of recession is in line with mainstream thinking among investors, my view on inflation isn’t. As I see it, market- and survey-based inflation expectations are too low and are likely to be revised up in the course of next year. The most likely trigger will be higher-than-expected actual inflation rates in the US and, possibly, Europe. One reason is that, in my view, the US economy is experiencing a structural slowdown in productivity growth, following a ten-year acceleration in trend productivity in response to the IT revolution, as US companies have now reaped most of the productivity-enhancing benefits of this revolution. Thus, labour costs per unit of output will rise more rapidly and potential output growth will fall. Moreover, the rise in the profit share to multi-year highs in the US and Europe suggests that some wage pressures are likely to emerge, supported by a growing consensus in society and political circles that workers should get a “fair” (read: higher) share of national income. Break-even inflation rates do not fully reflect these risks, and so I expect inflation linkers to outperform nominal bonds in 2007.

Tighter global liquidity, higher term premium. The experience of the last few years suggests that, even if short-rate expectations are revised up due to, say, higher inflation expectations or a better growth outlook, this need not translate into a rise in long-term bond yields, because this might be offset by a decline in the term premium. (Recall that the term premium is usually defined as the gap between the expected average short-term interest rates over the lifetime of a bond and the yield on that bond.) Most estimates suggest that the term premium has declined significantly in recent years (see J. Fels and M. Pradhan, Fairy Tales of the US Bond Market, 26 July 2006). While there are several competing explanations for the vanishing term premium, I continue to think that global excess liquidity, created by central banks around the world due to overly expansionary policies, is the main culprit.

While the Fed and the ECB are no longer expansionary on our measures, the Bank of Japan is still at the pump, and perhaps even more important, other Asian central banks along with their peers in the Middle East, Russia and Latin America are still flooding bond markets with excess liquidity as they recycle their growing external surpluses. Excess liquidity is unlikely to drop sharply in 2007, but it should become tighter at the margin. The Bank of Japan is likely to raise interest rates at least twice next year. Thus, G3 excess liquidity is likely to tighten further, at least until the Fed starts to cut interest rates. Moreover, with the global slowdown unfolding, Asian external surpluses will grow less rapidly or even shrink, and lower commodity and oil prices resulting from the slowdown would reduce producers’ revenues. Thus, Asian, Middle Eastern and Latin American central banks would have less fresh money to recycle into global bond markets, and so, somewhat paradoxically, weaker global growth would push bond yields higher.

Market outlook for 2007. I expect a combination of a global mid-cycle slowdown, re-emerging inflation concerns, and tighter global liquidity to push bond prices lower during 2007. In each of the G3 countries, I expect 10-year bond yields to climb towards and possibly break above their temporary highs reached in mid-2006 — 5.25% in the US, 4.15% in the euro area, and 2% in Japan. Investors should brace themselves for steeper yield curves and consider buying inflation protection. Euro area bonds should outperform US Treasuries in the bear market, as the upbeat expectations about European growth are likely to be disappointed. And with liquidity getting less plentiful and bond yields expected to rise significantly, risky assets will have a tough time repeating their stellar performance of recent years. Exit Dr. Jekyll, enter Mr. Hyde!