The bond bear has just begun

published 31 October 2005

Another bubble has developed in the US bond market, says John Paul Rathbone on www.Breakingviews.com. Renewed demand for US Treasuries has driven the yield on the ten-year government bond, which had soared after nearing 3% last June, back down to around 4%. Last summer's historically low yields could be ascribed to rampant fears of deflation and anaemic growth. Now, however, the economy is "galloping ahead", so the recent upswing in government paper "looks odd". Part of the surge is due to lingering concern over the sustainability of the recovery and the likelihood of interest rates staying low for an extended period, says Rathbone. But a key factor is a "massive carry trade" by US investors and their global counterparts: with the yield curve very steep, borrowing at ultra-low short-term rates and buying higher-yielding, long-dated securities brings "juicy profits". The crucial factor, however, is the "sheer financial firepower" of Asia's central banks, says John Plender in the FT. Led by Japan and China, they continue to pour their reserves into Treasuries in order to prop up the dollar and thus keep their currencies competitive.

The world's central banks have spent a total of $115bn that's - £1.4m a minute - to this end since September, says www.Dailyreckoning.com. Yet the greenback has kept sliding. Small wonder, then, that fears that they will eventually give up, thus triggering a "disorderly" fall in the dollar, are pervasive. A dollar collapse would prompt a sharp rise in short-term interest rates, which would end the carry trade and have a "bloody and swift" effect on the bond market, says Rathbone. But even without a dollar collapse, the outlook for Treasuries is bleak, says Brian Durrant in The Fleet Street Letter. The US administration has "embraced a whole cocktail of inflationary policies": short-term rates of 1% are "far too low" for a booming economy, and political pressure may keep them low until November; the "benign neglect" of the dollar will boost import prices; and the burgeoning budget deficit will lead to an increase in the supply of government paper. "Sooner or later", inflation - of which rising commodity prices are a harbinger - will filter into consumer prices, forcing the Fed to raise rates, says Porter Stansberry on Dailyreckoning.com. Long-term rates will then soar - and bond prices plummet.

UK gilts, meanwhile, are also hardly an "attractive proposition", says Gary Duncan in The Times. Not only is the economy recovering, but the "ever-rising funding requirement for the Government's debt" will engender a "flood" of gilt issuance set to "swamp" institutional demand, depressing prices and driving yields steadily higher. The 20-year bull market in Government bonds ended in June 2003, says Durrant, but it's likely that "the bear market in bonds has only just begun".