Prepared by Merrill Lynch & Co.
International Fixed Income Research
Global bonds appear set to enter their fourth consecutive year of declining yields. Global bond yields peaked in October 1994 following the mega-bear market that had started in February of that year, and have been trending lower ever since. The steepest decline occurred in 1995, with the median decline averaging close to 150 basis points. In 1996, the median decline averaged around 65-70 basis points, and has so far averaged around 50 basis points in 1997. Although the 1995-97 global bond market rally is still intact, the gains from maintaining aggressive long positions in global bonds appear to be getting smaller with each passing year.
One has to be impressed with the staying power of this extended global bond-market rally. Bond yields have fallen to record low levels in Japan and continental Europe, while U.S. bond yields are within 50 basis points of the cyclical lows reached in the fall of 1993. The 1995- 97 rally has been truly global in scope, suggesting that the individual financial markets around the world are becoming more tightly linked. It is particularly impressive that bond yields are falling in strong economies as well as in weak ones, and that this is happening regardless of rising or falling short-term interest rates. Out of the 16 major industrial countries, nine have actually seen their short-term interest rates rise in 1997. In contrast, all 16 countries have seen their long-term interest rates decline this year.
One could easily explain why the world bond markets posted impressive gains in 1995-96. Global economic activity had slowed down markedly from the rapid growth pace of 1994, and this contributed to a decline in global inflation expectations. But in 1997, leading indicators of global economic activity have risen sharply, and are now getting close to the peak rates of change last seen in 1994. In the past, this level of activity would have given rise to a major bear market trends in global bonds. But in 1997, this has not been the case.
We can explain why by examining the behavior of real yields and inflation expectations in the U.S., U.K., Canadian, and Australian index-linked/real-return bond markets. Real yields on inflation-protection bonds have moved modestly lower in the U.K., Canada, and Australia. Real long-term interest rates have only moved modestly because they are being pulled upward by stronger global growth, while simultaneously being pushed lower by declining budget deficits in the OECD economies.
In contrast, inflationary expectations in the U.S., U.K., Canada and Australia have all fallen sharply this year. It should therefore be apparent that the extended bull market in global bonds is being driven largely by a decline in inflation expectations around the world, with some additional support coming from moderately lower real yields.
Since actual inflation on a worldwide basis has been trending lower over time, inflationary expectations are likely to continue to trend lower until there is concrete evidence that actual inflation is reversing course. Until that time, the odds favor a continuation of the bull market trend in global bonds.
One of the interesting by-products of this extended rally has been a dramatic compression in yield spreads between the high- and low-yielding markets in the industrial world. We discussed this development briefly in our last bi-weekly review.
The yield spread between high- and low-yielding bond markets (excluding Japan and Switzerland) has narrowed dramatically in the past two years. There are a number of reasons for this. First, virtually all of the central banks in the major industrial nations have price stability as their primary goal. Therefore, inflation differentials among the major industrial nations have narrowed significantly. Second, as bond yields have moved steadily lower, yield-hungry investors have tried to stay ahead by overweighting the higher-yielding bond markets. Such actions have probably accelerated the move toward greater global yield convergence.
If we line up the major global bond markets (excluding Japan and Switzerland) from lowest to highest yield, we find that they all lie within a +/- 60-70 basis-point range around the current U.S. bond yield. The French, German, and Dutch bond markets stand at the lower end of the yield spectrum, while New Zealand stands at the upper end. Interestingly, only last week New Zealand's bond yields were roughly in line with those in the U.K. However, the announcement of a larger-than-expected current-account deficit (6.4% of GDP) in the latest quarter contributed to a sharp sell-off in New Zealand bonds this week. Since New Zealand's annual inflation rate is expected to average less than 1% this year, it is highly unlikely that this rise in yields will prove sustainable. For this reason, we would favor going long New Zealand bonds at current levels. One can position such a trade by going long New Zealand bonds and short French, Dutch or German bonds, on the view that global yield convergence will continue.
While long-term interest rates are converging globally, short-term interest rates have not displayed anywhere near the same degree of convergence. U.S. short-term interest rates are around 250 basis points above those in Germany, and around 150-200 basis points below those in the U.K. and New Zealand. With yield spreads wide at the front end but narrow at the back end of the global yield curves, it is evident that although yields on unhedged global bonds have converged, yields on hedged global bonds do not show nearly as much convergence.
This opens up a number of interesting trading opportunities, particularly for U.S. domestic bond investors. For example, for a U.S.-Dollar-based investor, the purchase of French, German, Dutch, Canadian or Danish government bonds, with the attendant currency risk hedged back into U.S. Dollars on a rolling basis, would offer a yield pick-up over U.S. Treasuries of around 175-200 basis points for a three- or six-month horizon. This is especially impressive when one compares the yield pickup available over U.S. Treasuries on comparable AA, A, and BAA corporate bonds in the U.S. domestic market. Hedged foreign bonds also compare favorably with the yield on U.S. below-investment-grade bonds. If U.S.-Dollar-based investors are frustrated with the relatively low level of yields and tight spreads in their own market, they should look to hedged foreign bonds as an alternative.
(Reprinted by permission. Copyright © 1997 Merrill Lynch, Pierce, Fenner & Smith Incorporated.)
October 9, 1997
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