Analysis & Comment:
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The Monthly Banker: 29 March 2012
What next for the economy? Thatís the big question for the central banks as they try and balance the tricky mixture of huge public debts, surprisingly sticky inflation and the need to support and stimulate the economy in the post-credit crunch world.
But the picture is not entirely clear. Earlier in the month, US Fed governor Bernanke appeared to be painting a fairly cheerful picture for the economic outlook. Over in the US, Q4 growth (2011) came in at 3%, a decent figure which exceeded analystís expectations. Looking forward, the Fed is expecting the economy to coninutue to grow at the rate recorded over the second half of last year, this being 2.25%. The tone of Bernankeís briefings were such that the market believed that the changes of a third round of quantative easing were no longer likely.
But few things change faster than sentiment, and by March 26th, Bernanke was telling the National Association for Business Economics the following:
"To the extent that this reversal has been complete, further significant improvements in the unemployment rate will likely require a more rapid expansion of production and demand from consumers and businesses, a process that can be supported by continued accommodative policies,"
Or, in other words, that the Fed will continue with its supportive policies - cheap money, and plenty of it.
What of the markets? Government benchmarks show roughly the picture one might expect - very low short end rates and a fairly steep yield curve thereafter. Some market commentators are highlighting the risk of low-yielding longer-dated bonds, and this is a fair point. However, we can expect the whole curve (see chart of US, Euro and GBP yield curves) to remain broadly anchored, at least for the moment, by the very low rates at the shorter end.
It is perhaps the equity market that is giving the most surprising signal. Investor confidence is a good leading indicator for economic recovery and the price action over in the US is strong. The Dow and the S&P500 are approaching their all-time highs and it is notable that the high-beta S&P600 Small-Cap Index has broken to a new all-time high. Bull market stuff!
One question to be asked about the strong performance recorded by the equity market is; are we looking at a symtom of recovery, or the side effect of the cure? Equity markets are known to lead economic recovery but it is possible that rising prices here are no more than a side-effect of the Fedís money printing. When you pump money into a system, you never quite know where it will end up!
Over here in Britain, economic growth is rather more ellusive. Indeed, the recent forecast from the OECD suggested that the UKís economy would contract by an annualized 0.4 percent in Q1 2012 before posting a sluggish growth of 0.5 percent in the following quarter.
That implies that UK rates will stay low for some time to come, and OECD chief economist Pier Carlo Padoan told journalists; "In the UK one might argue in favor of additional easing".
Looking at interest rate futures, traders expect LIBOR rates to rise gently. The table below shows the expectations for forward rates according to the interest rate futures market (note, LIBOR rates are slightly higher than the base rate):
So what should bond investors make of this? My view is that there is potential for economic growth, particularly in the US. In view of this, holders of very long-dated US government bonds should take care. Yields here are low; just 2.2% for the 10yr US Treasury bond. An upward move in rates (or the expectation thereof) will knock the prices of these bonds hard.
In the Sterling market, the same is broadly true. There is some risk, and rather less reward associated with long-dated gilts. However, medium-dated corporates present better value. Here, yields on offer range between 4 and 8%.
Whilst interest rates may rise in the future, I suspect it will not be that much, and possibly not for some time.