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Bond yields on upward trajectory Back  
Yields of US 10-year treasury and 10-year bunds forecast to increase.
Noel Griffin
The trend in bonds is similar to the interest rate position i.e. rates in general will be higher in the years ahead. However, as the bond market is more long term the yields are far less volatile. As can be seen in the position in the US while interest rates have fallen very sharply in the short term 10-year bonds are pricing in far higher interest rates. Short-term interest rates have fallen some 20 per cent from this time last year yet bond yields are broadly similar. With markets expecting short-term interest rates to rise, timing being the only issue, bond market yields will remain relatively high.

Eugene Kiernan
Government bond yields are headed higher. The first half of 2003 was as good as it gets for bond markets. We saw 10-year yields in the US pushed down to 3.1 per cent! Our view is that this number is on its way to 5 per cent. We don’t see the need for a substantial back-up in yields. Business activity has picked up but there are no run away economies, and inflation, in our forecasts, is relatively modest. We see short rates moving up from what are emergency low levels but still into 2005, Eurozone and US short rates are, in our forecasts, sub 3 per cent. This caps the upside in bond yields. We think this drift upwards will be greatest in the US as this is where we see a better economic outlook and relatively the biggest move in short rates. In Eurozone we are still waiting for growth to take hold. Also supportive in our view is that liability focussed investors will see merit in bond allocations not far from the levels we are forecasting.

Oliver Mangan
The recent back up in yields has been in line with our fundamentally bearish view on bond markets. We expect that the US market will remain under pressure over the balance of the year in the face of continuing strong economic data, rising inflation and a shift to monetary tightening by the Fed. By end year, we expect ten-year US yields to have risen to around 5 per cent. There is likely to be an even more pronounced rise in short dated US yields as the Fed tightens policy. We expect two-year yields to climb to around 3.3 per cent by end 2004 from 2 per cent at present. Thus, we look for a significant flattening of the yiield curve over the balance of the year.

The rise in eurozone yields has been less pronounced than in the US with an ECB rate cut still a possibility, and policy tightening not expected in the eurozone until well into 2005. There should be scope for the short end of the eurozone market, in particular, to continue outperforming the US over the balance of the year. At the longer end, ten-year eurozone yields are already trading 30bps through US Treasuries. This spread may widen somewhat further. Nevertheless, ten year eurozone yields seem likely to rise to 4.6 per cent by end 2004, from 4.1 per cent at present, dragged up by higher US yields. The relatively high level of official UK interest rates and prospects of further rate increases continue to weigh on the gilt market. Ten year gilt yields are some 85bps above bunds. This spread is unlikely to narrow much until the ECB starts hiking rates, which is not expected to happen until 2005. Thus, the ten year gilt-bund spread is likely to remain wide over the balance of this year.

Dan McLoughlin
US bond yields are very low relative to economic growth, anchored by the historically low level of Fed funds, This anchor may be about to move and when it does yields will rise sharply, moving to levels which are more in line with the normal relationship to economic activity. The more sluggish pace of Eurozone growth will keep bund yields below that of treasuries but the directional move will be the same.

Alan McQuaid
Global bond yield soared following the release of the March US employment report, and there will be more upside if the global economic recovery stays on course, as I expect. A behind-the-curve Fed will help prevent yields from rising too sharply in the near-term, but US 10-year treasury yields should climb to over 4.75 per cent by year-end and to 5.00 per cent and beyond in the early part of 2005. US Treasuries continue to buy into the Fed’s commitment to be patient about raising interest rates. The yield curve is extraordinarily steep, which is underpinning demand for longer-term maturities as long as the Fed is expected to remain on hold in the near-term. Foreign central bank buying of treasuries is also helping to suppress yields. But the bearish fundamental backdrop for bonds is clearly evident.

The wide disparity between economic activity and real bond yields is unsustainable, but also reinforces that inflation does not need to rise to pull yields markedly higher. Unless the US recovery falters, which is increasingly unlikely in my opinion, the outlook for treasuries is bleak. The forward-leading tightening by the Bank of England will likely push UK gilt yields up substantially in the short-term, but they should top out before yields in other markets do. In contrast, Eurozone yields will in the short-term be anchored by expectations of an ECB rate cut. Euroland bonds should out-perform global benchmarks on a 6-12 month basis. However, the overall reaction of Euroland bonds post the US March employment report, shows that there is still a very close correlation between treasuries and bunds even though the Eurozone economy remains in the doldrums. While bunds are likely to significantly out-perform treasuries over the remainder of 2004, the odds at this stage suggest it is likely to be in a bear market.

Donal O’Mahony
For the vast majority of financial market participants, the 1 per cent funds rate of the US Federal Reserve stands as one of the great anachronisms of our age, this 45-year low borrowing cost almost mocking in its unflinching response to the recent growth spurt of the US economy. It is the widespread view that such a debased borrowing cost is living on borrowed time that lies behind a prolonged investor antipathy towards the fixed-income asset class. Yet, for all the impatience exhibited by market strategists in repeatedly heralding the onset of a tightening cycle, those with the votes around the FOMC table are redefining the meaning of virtue in respect of their extended patient stance. For the Fed, the current monetary accommodation represents an ongoing exercise in risk-management, with Greenspan & Co alive to the risk that any policy error at this juncture could derail the economy from what is still a fragile re-emergence from post-Bubble disorder. Although the recent US growth dynamic has impressed all and sundry, the Fed is mindful that such performance has been significantly tailwinded by tax cuts, mortgage refinancing, dollar weakness, stepped-up auto incentives and lower oil prices, any or all of which may have morphed into headwinds in the period ahead. Absent their replacement by self-fuelling alternatives (viz income and credit growth), the risk of an unforeseen and decidedly unwelcome growth deceleration is far from negligible. For the Fed, any sustained loss of growth momentum at a time of continuous slack in both labour and product markets would be problematic for its attempt to develop a comfort zone for underlying inflation pressures. This is not the Fed of old, pre-emptively hiking interest rates to sustain a secular disinflationary trend. Rather, this is a Fed in opportunistic reflation mode, anxious to foster a sufficient narrowing of the US output gap in order to firebreak any further ‘unwelcome disinflation’ threats. This process will take time, but the Fed is patently more patient on this issue than are the markets themselves. Last January, Greenspan indicated the Fed’s acute awareness of the bond market’s ability to rapidly discount a full tightening cycle once the initial touch-paper had been lit by the policy authorities. This makes for an even more circumspect Federal Reserve, given common perceptions as to where a neutral Fed funds rate resides (circa 3.5 per cent). A tightening cycle will only be initiated when the Fed is absolutely satisfied that a hitherto debt-financed US growth dynamic has developed the wherewithal to withstand a potentially exaggerated interest-rate shock. That time is not now, nor indeed will it be for a considerable period.

Brendan Seaver
In the past, long-term government bond yields have been kept unusually low by deflation fears, central banks buying of US Treasuries, good liquidity conditions and historically low short-term rates. This made long-term yields out of line with fundamentals.Recently, this has been partly corrected as the market has become increasingly confident about the sustainability and the strength of the US economic recovery. Still, there is a gap that needs to be closed. The yield on the 10-year US note is likely to exceed 5.0 per cent by mid next year. The upswing in yields will nevertheless be capped by an inflation outlook, which remains broadly benign.

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