Differences of opinion can get ugly

There is also the possibility that the economic recovery may stall in the second half of the year as government stimulus wanes and the QE2 programme ends. The more compelling suggestion that developed market economies are undermined by rising oil prices is a further genuine worry, as wages are unlikely to keep pace with the rise in headline inflation, which will reduce consumer spending. Meanwhile, the U.S. housing market recovery and eurozone rebalancing process require interest rates to remain low, otherwise both are in danger of a sharp retreat.

So where do we stand in this debate? Back in October we suggested U.S. 10 year government yields could rise towards 4% and, given all the other uncertainties, much higher rates would seriously threaten the whole recovery. In a debate on U.S. government bonds yields, we cannot forget that the prices of U.S. Treasuries are used by much of the market as a 'base' price. If US yields do rise substantially, which could only happen when the Fed is in a position to raise rates, then the rest of the bond market (corporate bonds, mortgage bonds etc.) will be seriously affected. To see what could happen in that scenario, we refer to the experiences of 1994 as a guide. At that time, much market pricing incorporated anticipation of a low and stable central bank interest rate. This illusion was first shattered by the German Bundesbank, and then by the Fed.

This leads us to one of the most important differences of opinion regarding the situation today. The Fed and the European Central Bank seem set to follow different interest-rate policies over the coming six months. History has shown that such differences of opinion can become problematic for the markets and for particular currencies. U.S. dollar weakness has lingered for some time, and the eurozone continues to fight its peripheral battles; if the eurozone issues are resolved, then the euro could continue to recover against the U.S. dollar. The disasters in Japan suggest that Japanese monetary and fiscal policy will stay very loose for the foreseeable future. Some investors believe the yen could be a major funding currency for foreign-exchange traders (through sale of the yen and subsequent purchase of other currencies with more attractive interest rates), but others believe that repatriation of foreign assets by Japan will counteract this trend. These differences of opinion are likely to result in volatility, which could get ugly. We believe that repatriation is a near-term support, but lower credit quality and the loss of production are longer-term negatives.

A defensive position ("Plan A") in bond markets and reduction of underweight yen and euro positions is an appropriate stance to take while the outcome of crises in North Africa, the Middle East and Japan remain uncertain. "Plan B", appropriate for when economic growth recovers to the point at which markets price in a shift in developed-market monetary policy, and which is bearish for government bonds, may have to be postponed.