This is notably true of central banks, which are responding to their concerns about stronger economic and inflation indicators with further rate hikes.
We do not expect central banks to stop these moves away from their earlier accommodative policies soon. More rate hikes are in the pipeline. We expect the rate in the US to peak in the third quarter of 2006 at 5.5 per cent, and the European Central Bank rate to stop at 3.5 per cent towards the end of this year. As a result, our view is for 10-year bond yields in the eurozone to peak at about 4.3 per cent. As long as the restrictive policy of central banks remains efficient at holding down core inflation, the long end of the yield curve should rise to a lesser extent than the short end. This will lead to a flatter yield curve in the eurozone and the US. Government bonds should benefit from support when investors with long-term performance goals start buying bonds yielding above 4 per cent. The other factor in our view likely to favour government bonds will be the slowdown in economic growth that is expected to unfold in 2007. The higher central banks push rates, the more likely and extended the brake on economic activity will be. The outlook for credits (corporate bonds) and higher-yielding fixed-income classes is not looking as favourable compared with government bonds.
The financing of leveraged investments has become more expensive in the last couple of months, resulting in a sell off of these securities. This, in turn, has led to setbacks in more high-risk assets. Emerging market bonds were hit harder than high yield and corporate bonds. Demand for exotic asset classes, such as hybrids, has currently become almost non-existent. Liquidity in secondary markets is drying up for some bonds.
Based on the outlook for a weaker macro-economic environment next year, default rates are expected to rise. Furthermore, equity markets have become more volatile, which has been another factor beginning to push spreads in yields for corporate bonds wider from depressed levels. So far credit yield spreads have only partly priced in this scenario. In coming months, government bonds seem likely to outperform credits, before the spreads in yields of corporate bonds become more attractive relative to government securities later.
Christian Eckhert, head of European fixed income, ABN Amro Asset Management.
