These bonds may rise again

The renewed surge on Wall Street since the start of the year - the Dow Jones hit another record yesterday - has coincided with a sell-off in key bond markets around the world. It is not hard to see the reason. Investors have started to worry about the possible long-term inflationary consequences of the rush by central banks around the world to rekindle economic growth. While inflation and growth may be good for equities, they make bonds relatively unattractive, the more so after last year's sparkling performance.

A cautious note is being sounded by a number of houses, including Goldman Sachs. Gavyn Davies, its chief international economist, told a conference of investors yesterday that he expected bond markets to top out within the next three or so months. While global economic conditions continued to deteriorate, bonds should make further gains. But once the economic slowdown hit bottom, that would mark the peak of the bond market rally.

Underpinning this view is an outlook for the world economy that is both pessimistic and optimistic. In the short run, the plunge in activity could prove steeper than expected, with the possibility of a recession in the European heartlands. A shake-out in excess inventories is the main villain of the piece. By mid-year, however, the effect of recent monetary easing should bring about a sharp rebound in activity, all the more potent for being synchronised across all three major trading blocs, the US, Japan and Europe.

The question is whether the medium-term outlook is so rosy. The US recovery is five years old, making it the third-longest expansion in the post-war period. The US Fed now seems increasingly concerned about the possibility of recession. In Europe, a sharp cyclical reverse coincides with a deep- seated structural crisis in the labour market. With unemployment high and rising, consumers may choose to save more, weakening demand further. In Japan, all stops have been pulled out to revive the economy, but deflationary impulses remain strong.

If the slowdown does persist into the second half of the year, then gilts may do better than is generally expected. An optimistic inflation projection from the Bank of England later this week and a subdued picture of retail price inflation could give gilts the fillip they need to start retracing the losses incurred over the last three weeks.