LONDON, 13 June 2005 — In recent weeks the yield on the ten-year US Treasury bond has fallen to approach 4 percent. It hit this level in February and before then, twice in the autumn of last year. With the ongoing Fed tightening at the short end, an increasing number of commentators are predicting that the US yield curve will start to invert. An inverted yield curve is traditionally viewed as a good indicator of a recession.
While low yields on longer-dated bonds suggest a weak economy over the medium-term, several factors may be distorting the yield curve at present. One is the willingness of Asian governments to continue adding to their US bond portfolios as a bi-product of their foreign exchange policies. Moreover, actuarial advice may be pushing pension funds to purchase long-dated bonds irrespective of near-term expectations of investment performance.
There has been a very small difference between 2 and 10-year bond yields (i.e. a flat yield curve) obtained for much of the late 1990s, when the Federal surplus and absence of 30-year Treasury issuance may have created a supply shortage at the long end. However, this was a period of continuously strong growth for the US economy.
Thus the link between the shape of the yield curve (specifically an inverted curve) and the strength of the economy seems weaker than many expect. Therefore, if the yield curve were to invert, we should not rush to the assumption that a US recession was imminent. As it happens, the near-term outlook for US growth looks fairly good.
Investment seems to be picking up and consumer confidence is by and large holding up, helped by the still-buoyant US housing market. The weak dollar is obviously a support, even though the US unit has gained in value this year. Most encouraging has been the recent $10 per barrel drop in oil prices. The US is a relatively inefficient consumer of energy, so good news in this area can have a powerful effect.
So long as the world economy can cope with a continuing build up of dollar balances outside the US, we see a relatively weak up-cycle in the US economy remaining in place.
By contrast, however, growth in Europe and Japan looks set to remain anemic. All this suggests that this year’s recovery of the US dollar against the yen and euro may have
further to run.
As has been the case over the last decade, the altogether better growth environment is to be found in the developing economies represented by emerging markets. According to the IMF, economic growth in the developing world will have averaged 5.3 percent p.a. over the ten years to 2006, compared with just 2.7 percent p.a. for advanced economies. We see, if anything, an even wider gap between the growth rates of these two groups of countries over the next 12-18 months.
Ahead of the traditionally more difficult season for capital markets after the spring, we retain our cautious asset allocation for the time being. Bond exposure remains at 45 percent, with an emphasis on shorter-dated paper, and cash at 5 percent. We further retain our 25 percent weighting in alternative investments.
There has been much negative speculation on alternative investments following the downgrading of Ford and GM bonds to junk status. We would point out that such speculation often proves to have been wide of the mark once portfolio valuations are made and communicated. Also, while we continue to expect alternative investments to deliver superior returns to cash over time, monthly performance can be quite lumpy.
Thus the generally acceptable performance in 2004, largely depended on the last 2 months of that year.
We believe that the outlook for our low risk fund of fund vehicles is an improving one.
The imbalances in the global economic and financial system, e.g. the increasing US current account deficit, imply stronger investment trends which may therefore be easier to identify and to trade profitably.
In general, we do not believe that an aggressive policy with respect to equity sectors will be rewarded at the present time, and therefore favor a broad spread of exposure across the major industrial sectors. Finally on the currency front, we at present do not expect a significant move in US dollar exchange rates, but believe that with rising US interest rates an increasing number of commentators are turning more positive on the US currency.
(Habib F. Faris is vice president at Clariden Bank, London.)
(The information contained herein is for information only and should not be construed as an offer or a solicitation to purchase, subscribe, sell or redeem any investments. While Clariden Bank uses reasonable efforts to obtain information from sources, which it believes to be reliable, Clariden bank makes no representation or warranty as to the accuracy, reliability, or completeness of the information.)