Strathclyde Associates Government Bonds Part3- Market Outlook October 2010

By Author: Strathclyde Associate
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Market Outlook October 2010: Strathclyde Associates Government Bonds Part3
The strength of the major European bond markets must therefore also be viewed with some concern. The gilt edged market has followed the pattern of other markets and has also improved again over the past month.

The UK economy is currently performing better than expected; but the introduction of austerity measures to reduce the fiscal deficit is expected to limit further gains in the second half of the year. The Bank of England is also continuing to adopt a cautious approach, and is maintaining an easy monetary policy and low short-term rates; and there is no real risk of a default on UK debt. Investors have therefore been encouraged to push the market higher, and are obviously assuming that growth rates will remain low and that inflation will remain under control, even though it is currently well above the bank’s target rate.

The performance of the UK economy has been encouraging, and this has raised hopes that it might be able to cope with the impending austerity measures better than had been feared. For the moment retail sales ...
... are holding up fairly well, the level of unemployment is lower than expected; manufacturing activity is continuing to expand, and exports reached a two-year high level in June.

Strathclyde Associates Government Bonds Part3- Market Outlook October 2010: There are offsetting factors, including some weakness in the services and housing sectors; and the 1.1% growth rate in the second quarter of the year is not expected to be maintained; but most of the fears about a “double-dip” recession have been eased. However the situation remains uncertain. The Bank of England believes that the economy is balanced on a “knife-edge”, with “substantial” risks of a relapse balanced against signs of “gathering momentum”, and has stressed the need for “continuing monetary stimulus” in the face of a “choppy recovery”. Shortterm interest rates will clearly remain low for an extended period.

There is therefore much to support the market and to enable it to respond to an improving trend in markets elsewhere. Funding pressures remain high; but the Debt Management Office has recently announced that it is ahead of schedule on gilt issuance this year, and this success may well continue, especially if the sovereign debt crisis amongst the weaker members of the euro-zone continues to develop.

But there are doubts about the ability of the new UK government to successfully implement its austerity programme to reduce the fiscal deficit, and doubts about whether even a reduced deficit can be financed at existing yield levels. We therefore feel that care is necessary before investing in the UK.

The Japanese bond market has also improved again over the past month, and 10-year yields have moved below 1%. Recent figures indicate that economic growth has slowed sharply from an annualised 4.4% rate in the first quarter of the year to an annualized 0.4% in the second quarter, and there are fears that the country may be moving back into recession. This has increased expectations that the Bank of Japan will intervene in the markets to weaken the yen, as part of a further easing of monetary policy that will include further buying of government bonds.

Strathclyde Associates Government Bonds Part3- Market Outlook October 2010: There has also been evidence of Chinese buying of Japanese bonds as the authorities seek to diversify their massive foreign exchange reserves; and the combination of these factors has been more than enough to offset the massive government funding requirements.

However it is difficult to see how the present very low level of yields can be maintained unless the country is moving once again into an extended period of no growth and deflation. We do not expect this to happen, and so we feel that there is a risk of a significant Japanese setback.