Central banks in the U.K., Europe, Australasia and Latin America, are focused on the ill effects of inflation, which is rising at a rate that threatens to impair economic growth in their respective jurisdictions. This follows a period where these economies were attempting to stoke growth through monetary stimuli that led to lower interest rates and sizeable gains in bond prices. This is now changing.
A revival in economic growth at the same time commodity prices have gone parabolic has created a tortured environment for policymakers and global bond investors. Policymakers are attempting to discern whether the inflationary threat is real or just transitory. An error in judgment that causes inflation or a monetary tightening to exceed the boundaries of tolerance supported by the underlying pace of economic growth could renew fears of a slowdown or worse. Even in the U.S., where meaningful signs of inflation have yet to surface, the yields on Treasury securities have risen quite substantially from last fall, prompting predictions of a turn in the Federal Reserve's interest rate policy by year-end.
Recent reports on global manufacturing point to an expansion occurring not just in the markets where growth has been well established, such as the U.S., China, and Germany, but also in some that might surprise. Italy, for instance, had a reading that was the best in four and one-half years, while Ireland and Spain both reported increased activity. In the U.S., the ten-year Treasury bond yield recently breached 3.6 percent, more than a percent higher than where it stood just about five months ago. What is more remarkable still is the fact that the jump in yield is taking place while the Federal Reserve is deep in the midst of its asset purchase program, the design of which is to tame interest rates. In the absence of inflation to account for the move, the conjecture is that yields have responded to a pronounced tone of positive economic news that is building sequentially. Strengthening data in Europe along with an inflation scare in the U.K. have led to a breakout in bond yields on German Bunds to British Gilts.
The market has begun to price in the adoption of a more hawkish view from central banks in the advanced countries of the U.S., U.K., and Europe. Separately, emerging market countries have already begun a campaign to stem inflation with about half having raised interest rates at this juncture. Under this scenario, investors should be deliberate in their allocation to bonds and give duration measurement its due as a necessary ingredient to combat the prospects of a further weakening in global bond prices. The risk of being hyper-sensitive to encroaching inflation is that rising yields may actually act as a governor on economic activity, and therefore inflation, thereby becoming a self-limiting barrier to a further climb in rates.
We expect the beginning of a global bond bear market to form at or near the launch of monetary tightening in the U.S., Europe, and U.K. While recent comments from the three respective central banks do not suggest a period of significant tightening will get underway anytime soon, the market could begin to anticipate this outcome much sooner than the rate hikes are actually instituted. That could lead to more pressure on global bond prices than we have already seen. An always dangerous move is to extrapolate from recent events what the future holds as if it were to play out linearly. However, if forecasts for global growth prevail (the IMF predicts global GDP to advance 4.4% in 2011), and central banks ultimately "normalize" monetary policies, interest rates should move higher. That is the outcome global bond investors must brace for perhaps later this year.