Bonds crash as world economy shows signs of recovery
11 August 2003
Recent economic indicators show that the world economy appears to be finally making a firm recovery. Stock markets around the world appear not to be too impressed, but bond markets have been shaken.
In the US, the Institute for Supply Management (ISM) manufacturing diffusion index rose two points in July to 51.8, the first time since February that the reading has been above 50, indicating economic expansion. In the same month, the ISM index of non-manufacturing activity jumped to 65.1, the highest level since the survey was first conducted in July 1997, and well above June's 60.6. Recent surveys of US executives by Goldman Sachs and PricewaterhouseCoopers also reflect optimism over the near future.
Things are also looking up in other economies. British-based private equity group Cinven found that 33 percent of bankers polled across Europe expect the overall economic climate to improve over the next six months, with only 12 percent expecting conditions to worsen, compared with 47 percent six months ago. In Japan, private-sector machinery orders in June rose 2.4 percent from May, the second straight monthly gain in orders.
Prospects also appear to be brightening in Singapore. The Singapore Institute of Purchasing and Materials Management (SIPMM) reported that the purchasing managers' index rose to 51.4 in July, up 0.6 point from the previous month. A business activity survey by The Business Times and the National University of Singapore showed respondents expecting a recovery by the fourth quarter of this year.
However, the financial markets' reactions to these signs of recovery have been mixed. In spite of improving economic prospects, stock markets around the world have mainly been consolidating in July and August so far. On the other hand, bond prices have collapsed. US 10-year Treasury bond yields, which had fallen below 3.2 percent in June, are now back up to about 4.3 percent, near year-ago levels. In Singapore, 10-year government bond yields had fallen to 1.8 percent in May, but is now at 3.3 percent.
Why the contrasting reaction?
One reason is that stock markets had probably anticipated the improvement in business outlook earlier, accounting for the run-up to July. In other words, the recent favourable signs have been discounted and no longer move the market. Another reason is that the rising bond yields actually threaten the stock market, partly by endangering the economic recovery and partly by making bond yields competitive with equity returns.
On the other hand, bond markets had been expecting the US Federal Reserve to maintain a strong anti-deflation bias. When the Fed cut interest rates by only 25 basis points on 25 June and chairman Alan Greenspan spoke about an improving economy, bond traders realised that their assumption had been wrong.
In fact, bond investors in the US had earlier on been too complacent in pushing prices up and yields down. The risks should have been apparent. A burgeoning federal government budget deficit from President George Bush's tax cuts requires higher interest rates to fund. And despite some recovery recently, the US dollar is still considered overvalued by many, especially against Asian currencies. Further capital outflow -- or merely the lack of capital inflow to balance the current account deficit --would tend to push interest rates up. Ovveremphasis on the deflation threat by many observers -- including the Fed -- had caused bond investors to overlook these risks.
One investor who did not overlook these risks is billionaire investor Warren Buffett. This year, he has reduced his company Berkshire Hathaway's bond holdings by US$15.5 billion from the end of last year, to US$39.5 billion. He made US$600 million in capital gains by selling US government bonds in the second quarter. Buffett, of course, is an investment genius, and this episode confirms that fact.
The next question is where interest rates go from here. If the economy continues to improve, it is likely to continue to go up. In other words, bond prices would go down. That also means that stock markets, which have stalled in recent weeks, would resume their uptrends.
However, threats to the economic recovery remain. The increase in interest rates amid already high levels of debt in the US is a key concern. So is terrorism, especially after the bombing in Jakarta last week.
As long as investors are mindful of these threats and prepare for them by hedging or diversification, though, I think betting on a continued economic recovery, at least over the next few months, is still the right way to go.
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