Inflation jitters put bonds out in the cold

Europe's bond bears are growling again, forecasting a drop in government bond prices - and a corresponding rise in government borrow- ing costs - in the fourth quarter.

The Bloomberg News survey of economists' expectations for the European economy shows that demand for 10-year bonds is expected to slacken by year-end as central banks are spooked into raising official interest rates in order to keep a lid on inflation.

Those predictions come in the wake of similarly bearish forecasts for third-quarter bond performance. Some of these forecasts were off-target by as much as a percentage point."Everyone was looking for higher yields on the back of a better-performing economy that would have meant higher interest rates, but that didn't happen," said Kirit Shah, senior strategist at Sanwa International. "Yields are so low there is little money to be made. The market is over-stretched, and could snap anytime."

Two developments combined to make the forecasters look bad last quarter - US Treasury yields continued to sprint lower as inflation remained benign in the world's largest economy, while the introduction of a single European currency looked likely to go ahead as planned in 1999.

Justifying their pessimism for the fourth quarter, economists point to the prospect of the first official German interest rate increase since December 1992, with the Bundesbank poised to move its repurchase rate from 3 per cent, where it's held since August 1996.

"We expect the German repo rate to be 30 basis points higher by the end of the fourth quarter," said Philip Tyson, an economist at HSBC Markets. The median forecast of 16 economists calls for a 20 basis-point rise to 3.2 per cent.

For Germany, that means 10-year bond yields rising by about half a point to 6 per cent by the end of December.The median forecast for French 10- year yields is 5.78 per cent, up from about 5.50 per cent on 30 September.

In the UK the forecast is for yields to rise to just above 7 per cent, up from 6.45 per cent at the end of last month. With housebuyers opting for fixed-rate mortgages, a rise in bond yields would make it more expensive for banks and building societies to borrow in the wholesale markets.

As in the third quarter, however, the doom merchants could be defeated if the US Treasury market continues the rally which has driven the yield on the 30-year bond, the bellwether for world bonds, down by half a point since mid-year to about 6.3 per cent currently.

With the Federal Reserve appearing to have achieved the combination of growth plus slow inflation, investors have been willing to drive bond yields lower, ignoring the inflation warnings of bond analysts. "The problem for analysts is that we've grown up associating growth with inflation," said Gerd Neitzel, manager for Siemens in Munich. "It's a new world. It's hard to get used to deflation or non-existent inflation."

Neitzel believes demand for bonds will remain strong, and the majority offering bearish forecasts will be proved wrong. "If the US gives a lead, the others will follow," the fund manager said. "If you ask me where yields will be in six months, I would say the same level, or probably a bit lower."

He sees scope for the US 10-year yield to drop by about a quarter point by year-end to 5.75 per cent. "Why shouldn't Germany then be at 5.25 per cent?" Neitzel said.

Bond markets did better than expected in the third quarter, undoing the market decline forecast by economists polled in June. For Germany, forecasts for a 6 per cent 10-year bond yield were higher than the 5.52 per cent rate achieved at the end of the third quarter, with forecasts for French yields missing out by half a point.

In Britain, bond yields were supposed to soar to 7.25 per cent, a quarter- point rise from mid-year. Instead, the market awarded the Government better than a half-point cut in borrowing, as well as pushing the UK's funding costs closer to Germany's.

It was the performance of Europe's higher-yielding bond markets, however, that caught analysts off guard. The political will to ensure that monetary union goes ahead outweighed difficulties would-be members have in meeting the economic targets.

Italian 10-year bond yields hit 6.18 per cent at the end of the third quarter, dropping 70-odd basis points in the three months to beat the 7.25 per cent median forecast by better than a percentage point. Spanish bonds outstripped expectations by a point.

"Although people were bullish about EMU convergence, the intensity of the convergence took everyone by surprise," Shah said. "The momentum is irreversible; markets reinforced that."

Investors who've made returns of better than 10 per cent in the European bond market are likely to get antsy about those investments as the end of the year approaches, tempting them to book profits. The Bundesbank and the Fed are likely to raise rates at the first sign that inflation is accelerating, and the German central bank may feel compelled to act next month.

"There could be a setback," said Shah, who predicts a quarter-point rise in German rates by year-end and a Fed rate increase in November. "If there's a scare, people will take profits."

With additional reporting by Shobhana Chandra

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