IS THE LONG TERM RALLY IN GLOBAL BONDS ACTUALLY OVER, MID MONTH UPDATE

The continued rally in the bonds of developed markets like US, Germany, UK etc has continued to intrigue most analysts over the last few years.  Some of the most prominent and well known bond investors gave a call over two years back that the two decade plus rally in global bonds is over for good. However, at that time the 10 year bond yields in the USwere near the 3.8-4% mark. From there the US bond yields fell to below 1.5% as the US FED pursued its bond buying program with great vigor. Similar has been the movement in the bond yields of the other so called safe haven countries like the UK and Germany.  However, now that the economies in the developed world seem to be stabilizing and growth is picking up in the US there is a strong possibility that the US FED will start withdrawing the extremely accommodative monetary policies earlier rather than later. Credit conditions in the EU have also stabilized with the bond yields of the troubled countries like Italy, Spain etc now back to pre crisis levels and short term borrowing costs in these countries have fallen to all time lows.

This has happened in combination with the continuous up move in key global stock markets where US & German markets are now at all time highs and a number of other markets are at multiyear highs.  A market like Japan has rallied by nearly 80% over the last 6-7 months itself.  As a result of improving economic outlook, expectations of lower monetary stimulus as well as withdrawal of crisis measures we have seen bond of the “safe haven” countries sell off sharply over the last two weeks. This is quite contrary to what is happening in India where the sharp fall in inflation has led to a huge bond market rally.

Data actually suggests that the great rotation has not yet started in any big way. There is not much sign of money moving from bonds to equities, although incrementally equities are getting money now.  The key is that low interest rates have been one of the major reasons for the revival in the US economy and as such a sharp uptick in rates might lead to the recovery stalling. However the main point is how high a movement in interest rates is too high. As we see from the chart the major resistance on the upside is around the 2.4% range for 10 year USbonds.  It seems very likely that we will see the bond yields eventually move to that level over the next several weeks.  However, clearly looking at things both at a fundamental as well as technical level it seems too early to call an end to the long term bull market.  Fundamentally there are still issues related to poor job creation and high joblessness in most developed economies. Economic growth is still extremely anemic and is likely to remain subdued for an extended period of time. As such after the initial spike up from extremely low yields the further up move might be slow. Ultimately as we see from the long term bond yield chart the upper end of the downward sloping channel stands at around the 4% level and as such as long as the bonds trade in this range the long term trend is not really broken.  The realty also is that even after a sell off even till the 3.5-4% range interest rates will still be extremely low taking into account a long term perspective. As such recovery should not be stalled till rates move much higher as borrowing costs still remain constructive for growth.

Now if we go back to the last bull phase in equities we see that the bond yields went up from 3.1% in the year 2003 (when the bull phase started) to a level of around 5.2% till the third quarter of the year 2007. As such the move was around 2% from top to bottom. A similar move should happen over the next few quarters where the bond yields should move to the upper end of the channel. Normally such moves are accompanied by strong equity market rallies; let’s see how it plays out this time.

The first move where I had expected that the US and German markets will move to all time highs has fructified. As per a latest survey of fund managers it has been found that the overweight position on EM’s is very low and most investors have concentrated on DM’s. A shift in interest is imminent going forward and we should in all probability see Emerging Markets outperform over the course of the remainder of the year 2013. Obviously it does not mean that there will be no volatility, there should be bouts of volatility in between. The DOW is up 16%, DAX 9.5% & FTSE 13% YTD. Most BRIC’s markets are either flat, down or marginally up in the same time period.  As credit conditions become benign & risk taking increases we will see money move more into second tier markets.

In the Indian context the results season has been reasonably good relative to the extremely low expectations that were built up. As I had expected the WPI inflation has collapsed and will remain subdued for an extended period of time. The moderation in CPI has just started and we should see levels of 7% by July and 5.5% by September.

Contrary to RBI commentary, they will be forced to loosen monetary policy significantly. This in turn will be extremely positive for the revival of the economy as well as corporate earnings growth. The moderation in input costs has already had a positive impact on company margins, but for the operating leverage to come in we also need a revival in the economy that will boost the topline. The revival of the investment cycle requires more action from the government, the progress of which will be keenly watched. As such my base case assumption of a 15% return in the year 2013 seems to be on track. Upsides will depend on government action.