ZS: In Europe and the US, bond yields have been hitting record lows since the start of the year. Is this the effect of the Asian financial crisis?
PA: Yes. Investors have recognised that the problems in Asia are going to affect monetary policy within OECD countries. Whereas previously there was an expectation of rising interest rates, people are now more relaxed about the outlook.
ZS: What's the mechanism for that effect?
PA: The US economy and, to a lesser extent, European economies looked like they were growing too rapidly, so investors were expecting central banks to raise short-term rates this year to choke off the threat of inflation. Lower growth in Asia will limit export growth in the West, cooling overall growth, removing the need for precautionary rises in rates.
ZS: What will the US Federal Reserve be doing this year?
PA: Markets now expect no tightening of US monetary policy this year and some investors even speculate that rates will come down. That is probably already priced into the market and it is not a reason for buying US bonds at these levels. In order to get further progress, investors would have to expect a whole series of rate cuts and that would imply a degree of economic slowdown which isn't likely to happen. There is enough life in the US economy, driven by its consumer strength and the buoyant labour market, for it to remain firm even if export growth does slow down. We do not expect the Fed to cut rates aggressively. So we are in the final stages of the recent bond rally now.
ZS: Where do you see the yield on the 30-year US Treasury bond by the end of the year?
PA: We expect to see it 25 basis points higher than its current 5.75 per cent. On a three-year view we still see bond yields drifting down gradually, but to get to new lows you need an economic slowing, which will not happen in 1998. It will probably be in 1999 or thereafter.
ZS: Over the long term you are still bullish on Treasury bonds?
PA: Yes, not just because short-term rates will come down eventually. The pattern of supply and demand in US bonds is healthy for bond prices. The US fiscal deficit is improving, which will reduce the supply of government bonds as investors look to put more money into bonds from cash. But on a six-month view, we think we have come too far, too fast.
ZS: The Bank of England left rates unchanged this month. Was it right? Do you see more rises this year?
PA: It was the right choice because there is so much uncertainty about where the problems in Asia will end that it would be unwise for any central bank to move until the picture is clearer. Looking longer term, we think it will have to put up rates again. The UK is like the US: both economies are being driven by consumer demand, and we think the UK economy will do very well this year despite Asia's problems. UK inflation is higher than the government target and it's not showing signs of falling. We don't think the economy will slow enough to bite into that inflation so the Bank's work is not finished. It will have to tighten again.
ZS: That may be true for the first half of 1998, but what about the second? Will the economy slow then?
PA: It is certainly priced into the market, as bond yields are lower than deposit rates. We have an inverse yield curve at the moment, reflecting expectations that rates will be cut very quickly once the Bank finishes tightening. But we think the market is getting ahead of itself. There may be a neutral stance on rates for a while when the Bank has finished tightening before it can start cutting. We think it is likely to be 18 months before rates can fall, so the market is too enthusiastic.
ZS: What are the implications of that for sterling?
PA: That leaves sterling underpinned as the pound is helped by higher short-term interest rates. The pound is overvalued on a traded goods basis at these levels but while rates are high it would be dangerous to bet against sterling.
ZS: What is your forecast for the Bundesbank?
PA: The Bundesbank will be tightening rates gradually during the year, but not dramatically. Rates may go to 3.75 per cent or 4 per cent by the time the euro is created at year-end, but the markets have rightly been revising down their expectations of the tightening in Europe. It's difficult to be precise today as we do not know how the future European Central Bank will manage monetary policy. We know the goal in the long term is to keep inflation under control, but how they will do that is unclear. But there isn't enough strength in the European economies for anything more than a gradual uptick in short rates over the year.
ZS: Where do you see the European Central Bank setting rates at the outset of the single currency?
PA: At the beginning of next year, we are pencilling in 3.75 to 4 per cent, a good half point higher than core European rates today. That's only fine tuning when you look at the long-term trend in short rates and not nearly as high as expected even a few months ago. The impact of Asia's crisis will reduce the need for the European Central Bank to act aggressively in the early days.
ZS: Where are the best opportunities in world bond markets?
PA: On a long-term view we still expect bonds to outperform cash even though right now we would be booking some profits. A diversified portfolio containing both US and European bonds is attractive. We would not want significant investment in Japanese bonds at the moment and it is certainly too early to look at the emerging markets. One market which offers good value is New Zealand, which has been very volatile because the central bank targets the monetary conditions index. Investors will need to be patient.
ZS: Where should individual investors in the UK put their money?
PA: If they are investing in bonds, we would view continental Europe as attractive. Gilts have performed well in the last few months and we don't think it likely they will continue outperforming the rest of Europe. Now is the time to diversify, andEurope is the best place to go.
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