24th February 2011
Schroders head of UK and European interest rate strategies David Scammell says that without a new global downturn, a risk flare up such as the collapse of the big bank or distress in the periphery of Europe, yields look set to move higher bringing lower prices.
"The rationale for buying bonds has clearly diminished," he says.
Scammell also says that bonds have been supported over the past few years by exceptionally low interest rates and fears of a double dip as quantitative easing measures are withdrawn.
But the risk of a double-dip recession is receding while global growth looks firmer thus diminishing ‘safe haven' flows of money to bonds.
He adds: "Central banks seem set to move away from fighting deflation towards a more neutral policy stance.
"This means tightening monetary policy (an end to quantitative easing) and raising rates. The markets are now beginning to discount this tightening cycle and yields are moving higher. We would expect this process to continue, and are subsequently underweight bond-exposure."
However the fund manager believes any bond sell off could be limited with the possibility of Asian growth being curtailed by higher interest rates, tight credit in developed countries, and austerity measures limiting growth in Europe's periphery.
He says: "Given the uncertainty, central banks may prefer to keep policy rates relatively low – away from zero but well below neutral rates – and this could limit any bond sell-off."
On the other hand, the manager says a sustained rise in commodity prices and the reluctance of some western central banks to acknowledge the accompanying dangers could push up inflation.
Scammell says the one certainly is supply due to the mess that developed countries' finances are in.
However apart from sovereign wealth funds, overseas central banks and banks forced to hold bonds for regulatory reasons, he is unsure where demand will come from.
"The result is likely to be a grind higher in yields. Thus, it seems reasonable to expect equities to outperform bonds in upcoming years."
Scammell expects inflation-linked bonds to remain popular while corporate bonds should outperform government bonds and corporate default rates will remain low.
He adds: "The extent of any multi-year sell-off should ultimately be determined by inflationary considerations. Bonds have clearly benefited from a low global inflationary environment for 20+ years. Any hint that we are moving into a more inflationary world could have devastating consequences."
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