US will lead global bond market rally

American and European bonds rallied over the quarter in anticipation of slowing US economic growth, but the outlook for British bond markets remains unfavourable as inflation fears persist.

Inflation around the world has surprised on the upside for much of this year, but the anticipation of a slowdown in economic growth has seen a rally in global bonds in America and Europe that is set to continue into 2007.

The outlook for US Treasuries, in particular, has improved over the past few months. After 17 consecutive interest rate rises in an attempt to dampen consumer spending and take the pressure off inflation, the Federal Reserve’s tightening cycle finally paused in June as American economic growth started to show signs of weakening.

The outlook for US growth continued to deteriorate throughout the third quarter and into the final quarter of this year, fuelled in the main by the slowdown in the housing market, which has been one of the driving forces of the economy over the past few years.

In recent months sales of both new and existing homes, as well as demand for housebuilding permits, has slowed markedly. Although American consumer confidence remains robust on a historical basis, the effect of the drop-off in home sales is expected to slow consumption over the coming quarters and the market consensus points to a continued slowdown in GDP growth into 2007. However, inflationary pressures have eased off thanks to the recent drop in the oil price. After rising from less than $20 a barrel in 2001 to almost $80 this summer, the oil price has since fallen by 22%.

And with inflation likely to decrease over the coming months as commodity prices come off current elevated levels, the Fed will probably leave interest rates unchanged at 5.25% for the rest of the year.

At present, we hold an overweight duration position, mainly as we believe that American interest rates have peaked and economic growth is softening, both of which are positives for bond markets. On a break-even basis, US Treasury inflation-protected securities look reasonable value relative to conventional bonds despite the improved inflation outlook.

In Europe, inflation has also surprised on the upside but bond investors are confident that these inflationary pressures will ease. Although the economic prospects for the eurozone are robust, the effect of a continued slowdown in American growth poses the question of whether Europe can pick up the slack. In our view, this will be difficult and Europe is likely to feel the impact of a slowdown across the Atlantic, with its growth still very much dependent on exports. Add to this the restrictive fiscal measures in Europe and the economic outlook for the rest of this year, and especially into 2007, is likely to become more balanced.

Owing to continuing strong credit growth and the short-term upside risks to inflation, we expect the European Central Bank to raise interest rates one more time in 2006 and again at the start of 2007. Looking ahead into the first half of 2007, the ECB is likely to pause as economic growth and inflation in the eurozone are expected to soften.

The outlook for euro government bonds is positiveas limited supply, strong demand from liability-driven investors and the slowing macroeconomic backdrop provide support for the market. Therefore, we are overweight duration and, on a break-even basis, favour European conventional government bonds relative to inflation-linked bonds, which we believe will lead the rally in the next three months.

Where the story has been a positive one for European and American bondholders, in Britain rising inflation has been met with the greatestsurprise of all and market conditions remain unfavourable for bondholders for the foreseeable future.

At the start of the year investors expected interest rates to remain at 4.5%, but the buoyant housing market and continued rise in the Consumer Price Index and Retail Price Index led the Bank of England’s Monetary Policy Committee to unexpectedly raise interest rates in August and again this month.

As FTSE markets continue to soar and reach new peaks, the tightening cycle will continue. A third hike is on the cards in the new year and there has been talk of a possible fourth in May. Short-dated bonds have suffered as the MPC’s cautious approach to inflation continues.

Long-dated bondholders should do well. However, the overall picture for British bondholders is likely to be one of flat performance as the MPC remains on a tightening bias.

Looking forward, all eyes will be on the American economy. How the economy fares and the Fed’s next moves will be key drivers of global bond market performance over the next year, as they have been for the past six months. America looks likely to lead the global bond rally and, as a result, US Treasuries are our favoured bond market.