Bonds: Another Solid Return Expected

Monday, January 28th 2002, 12:50PM

In a year in which equity market returns were disappointing, bonds showed their value in 2001 as diversifiers in a balanced portfolio.

In response to one of the most aggressive interest rate cut period by the US Federal Reserve in recent history, US long dated government bond yields fell sharply in 2001 to a low of around 4.2% in October.

However, what was looking like a very solid performance was dented to some extent by the sell-off of the bond market towards the end of last year. During November, the US bond market had one of its worst fortnightly performance with the yield on US 10 year Treasuries climbing sharply to around 5% as markets began to factor in a near-term US recovery.

For the year the Salomon World Government Bond Index (hedged) recorded an 8.2% return. This was down on last year’s 11%, but the out-performance to equities was still significant.

We anticipate that returns in 2002 will come close to matching last year’s if our assumption about a less than spectacular US recovery, benign inflation and Federal Reserve reluctance to tighten proves to be correct.

Markets have already started to factor in a Fed tightening beginning mid-2002. However, we expect the Fed to be patient for much longer than most are expecting.

Indeed we believe there is a good chance the trough in the Fed funds rate has not been reached with one, maybe two more 25 basis point rate cuts likely over coming months pushing the policy rate down to 1.25 per cent.

Several factors are likely to keep the Fed on hold for most of this year. First, we expect only modest US economic recovery in 2002 with more downward momentum in the world economy for some time yet.

As a result the Fed is more likely to be motivated by a desire to avoid a rise in long term rates that could de-rail a nascent recovery. Second, excess capacity means that economies are operating well below trend. There is ample room to aggressively stimulate growth without risking inflation. With headline inflation in the US trending down sharply in recent months, we consider a short period of deflation in late 2002 a greater risk than a damaging surge in prices.

Currently bond markets are not priced for such a scenario and we would expect US 10 year bond yields to retrace a large portion of the back up seen since November with yields falling as low as 4% by mid-year.

In the second half of the year, firmer signs of growth will likely see yields move higher, but given our view on the strength of the recovery we still expects yields to finish the year below current levels.

What are the implications of a move back to budget deficits in the US? In recent years the trend has been towards budget surpluses, but there is a good chance that depressed activity and a massive fiscal stimulus will turn this around over the next couple of years. However, we believe that a move back to deficit and increased Treasury supply will have only a modest impact in pushing Treasury yields higher

All in all, we expect world bonds to have another good year, helped by falling inflation.

Geoff Mason is the manager of investment strategy at BNZ Investment Management.

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