Environment for Bond Markets Remains Constructive

  • Slight slowdown in growth next year
  • European Central Bank should raise the key interest rate to 3.75% in the first quarter 2007
  • Euro / US dollar in a sideways movement, Japanese yen expected to firm up

The global economy is showing strong growth for the fourth consecutive year. The key question for the financial markets now boils down to how pronounced the economic downturn will be next year. According to Gerhard Winzer, major markets interest rates and currency analyst at CA IB “the economy should have a 'soft' landing next year. The precursory economic indicators are only slightly weaker, there has been a marked fall in the price of oil since the record high in August, and there is little danger of sharp rises in key interest rates which would strangle the economy.”

The surprisingly solid economic growth in the euro zone is remarkable. Gross domestic product is expected to grow by 2.6% this year and should only fall off slightly to 2% next year. At the same time inflation is at an elevated level this year at 2.2% p.a, and next year will only decrease slightly to 2.0%. Furthermore, ample liquidity is accompanied by strong monetary and lending growth. This means that the monetary policy of the European Central Bank is still too expansive. The ECB will raise the key interest rate from 3.25% at present to 3.50% in December and 3.75% in the first quarter. 

End of Interest Rate Hikes in the USA
In contrast to the euro zone, the cycle of interest rate hikes in the USA has come to an end. In view of slower economic growth (2006: 3.2%, 2007: 2.1%) and falling inflation (2006: 3.4%, 2007: 2.7%), it is only a matter of time until the key interest rate (currently 5.25%) is lowered. By the end of 2007 it will probably be at 4.75%.

The dominant investment theme on the capital markets is carry trades: Money borrowed at low interest rates is invested at a higher interest rate. There is consequently strong demand for high interest currencies (e.g. Brazilian real, Australian dollar), spread products (i.e. emerging markets and corporate bonds) and steep yield curves (e.g. yen curve).

Positive Scenario for Bonds
The environment for bond markets remains constructive  The only slightly weaker pace of economic growth, efforts by the central banks to combat inflation risks, surplus capital and low volatility will continue to keep reference yields in the USA and the euro zone low over the entire spectrum of maturities. This implies persistently flat yield curves. Raising key interest rates in the EMU to above 3.75% could even lead to a temporary inverted curve structure, i.e. long-term yields could fall below short term yields.

The yield on 10-year German bonds should hover at around 4.00%, while the yield on 10-year US treasury bonds will probably move within a range of 4.50% and 5.00% The outlook for spread products is also cautiously optimistic, although there an increased risk of a correction.

Exchange Rate Outlook
On the currency markets, the US dollar will probably move sideways against the euro (around 1.28). However, the risk of a weaker US dollar remains. Contrary to forecasts, the US economy could experience a strong economic downturn.  In this case, fears would emerge again about the US ability to finance its current account deficit. 

The yen is undervalued against both the euro and the US dollar. However, at present there is no stimulus that could trigger a strengthening of the yen. In the short term, the emphasis placed on inflationary risks by central bankers at the ECB and the Fed, as well as the recently rather weak Japanese economic indicators are keeping the yen on the weak side. However, by the end of 2007, the yen will probably have firmed up against both the dollar and the euro (to 113 and 145 respectively).

The same applies to the Swiss franc. As long as the appetite for risky investments remains strong and the European Central Bank continues to raise key interest rates, the Swiss franc will remain weak against the euro (between 1.59 and 1.60). In the medium term, however, it will probably strengthen somewhat.

Enquiries: Bank Austria Creditanstalt  International Markets
Veronika Fischer-Rief, Tel.: 050505 Ext. 82833,  e-mail: veronika.fischer-rief@ba-ca.com



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