Investors are increasingly convinced that US monetary officials have succeeded in keeping inflation low even as the economy grows. Consumer prices have risen just 0.2 per cent in each of the past four months, while the economy grew by 3.3 per cent in the third quarter.
US bond yields have been higher than those of their German counterparts since April 1996, as investors demanded a bigger premium to lend to the US government amid concern that the rally in the world's biggest economy would stoke inflation, eroding the fixed return on bonds. Ten-year US bonds yield about 5.93 per cent on an annualised basis, compared with German levels of about 5.5 per cent. The gap between the two has halved in the past six months, and is about a quarter-point below its six-month average.
"I think bond yields will stay low, but fall more in the slowing US economy than in the economies of Europe," says Rabbani Wahhab, at GH Asset Management. "Global demand will be surprisingly weak in the next 18 months, and 10- year US yields can easily fall to 5.25 per cent in 1998."
A Bloomberg News survey of 46 investors, economists and traders showed that 37 respondents expect the yield gap between US and German bonds to narrow by mid-1998 to 35 basis points. Some even see US yields falling level with or below German yields. Only nine forecast a higher yield premium by the middle of next year.
Two features are likely to dominate global bond markets over the winter. A slowdown in Asian economies, as crumbling stock markets combined with the collapse of Japanese and other financial institutions call a halt to company investment plans, is likely to brake global economic growth. It is tough to quantify how marked the impact of reduced demand from the so-called tiger economies will be, but there is a growing consensus that the effects will be felt before long.
In Europe, meanwhile, the approach of the 1 January 1999 start date for the single European currency means that the bond yields of countries likely to qualify for the euro have to converge some time in 1998. There is still some work to be done there; Spanish yields are still about 30 basis points higher than German levels, while Italian debt offers a premium of about half a point.
"I am thinking we will get higher European yields," says Roy Adams, manager at QBE International. "People are beginning to raise an eyebrow at the thought that European bonds will converge somewhere about the current bund level. That looks a bit difficult."
The German government is forecasting growth of 2.5 per cent this year, rising to between 2.75 per cent to 3 per cent next year. That is likely to prompt higher interest rates in Germany - driving official interest rates elsewhere on the Continent upwards - to keep inflation at bay. Those higher central bank interest rates look likely to push bond yields higher.
Moreover, while the German economic recovery has so far been powered by exports, many economists are expecting domestic demand to recover in 1998. This should inoculate the European economies from the effect of the anticipated slowdown in Asian demand for goods from Western manufacturers.
"I'm looking for domestic demand to pick up, and looking for the Bundesbank to put up rates," says Mr Adams at QBE. He sees the German-US yield gap shrinking to 35 basis points by year-end and disappearing by mid-1998.
Those investors who do not expect the Treasury market to outperform German bonds are the ones not persuaded that Germany's domestic economy will rebound in 1998. With many German citizens still viewing the loss of their beloved deutschmark next year with trepidation, uncertainty about the outlook for the economy after monetary union might keep German shoppers at home.
In the US, meanwhile, the Commerce Department last week cut its estimate for third-quarter gross domestic product growth to 3.3 per cent from 3.5 per cent. Economists had expected growth to be revised upwards, to 3.6 per cent. And, while growth was unchanged from the second quarter, it has slowed from a first quarter surge of 4.9 per cent.
With US growth already losing momentum after the Federal Reserve applied the brakes by raising rates at the end of March, slacker economic demand in Asia is likely to exacerbate the slowdown in the US - which is good news for Treasury bonds.
"The US economy will slow, driven by the combination of a falling export market, as well as spending falling at home. We saw the first snippet of that in the GDP revision," says Mr Wahhab at GH. He expects falling US yields to push the 10-year bond yield to within 35 basis points of German bonds by year-end, and to level-pegging next year.
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