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Thursday, July 03, 2003

Bond Market Fears

As we have been saying here all week, in matters economic timing is all important. After the collapse in the equity markets money fled, partly to property and partly to the bond markets. Now both the property and the bond markets are under pressure. Fears of public finance problems are undermining the bond markets, driving up longer term interest rates which may have some importance for investment plans, which could in turn put a break on the recovery. The real question here is how to break out of the circle.

Investors shunned British and German government bond market auctions on Wednesday, fuelling fears that the three-year old bond "bubble" has passed its peak. The poor response coincided with a further fall in the price of US Treasury bonds, which hit a seven-week low during the day before recovering by the close. Demand for bonds is being hit by concern about deteriorating public finances in most large economies and by renewed interest in equities as hopes of economic recovery rise and fears of deflation fade.

But a fall in bond prices could threaten to choke off the stock market revival and undermine recovery. Yields on benchmark US and German 10-year bonds are already up almost half a percentage point from their lows in the middle of last month. In Britain, Wednesday's £2.25bn ($3.8bn) gilt auction was covered only one and a half times, lower than would typically be expected. In Germany, the sale of less than €6bn ($7bn) of new 10-year government bonds - known as Bunds - was only 1.4 times subscribed, the second-lowest level of interest in a bond auction this year.

Ciaran O'Hagan, fixed-income strategist at Lehman Brothers, said the German government bond auction was "the worst I have ever seen in my 12 years of following the market". Since the end of the share price bubble in 2000, a flight away from equities and into bonds has driven bond prices up - an ascent many analysts have seen as another bubble waiting to burst. In the past few months, equities have recovered strongly: the S&P 500 is up 29 per cent from its trough last October. But a drop in bond prices could upset the recovery in share prices. "The biggest prop to the stock market has been low bond yields," said Eric Lonergan of Cazenove. "We have just had a very strong quarter for equities, and now one of the supports for that is being taken away."

Falling bond prices - which mean rising long-term interest rates - also threaten to undo efforts by governments to establish a robust global recovery. Rising bond prices have cut the cost of fixed-rate mortgages in many countries and fuelled consumer spending, particularly in the US. Companies have also been able to refinance debts more cheaply. These supports for growth would be undermined if bond prices continued to fall. Sentiment has been undermined by deteriorating public finances. The German government has announced that it expects to have to borrow €35bn this year, nearly twice the €18.9bn announced in its draft 2004 budget. The US faces a $300bn budget deficit - its largest ever - in the year ending September 2003. Germany is widely expected to exceed the EU's 3 per cent limit for deficits as a share of gross domestic product for three years in succession. An auction of Japanese government bonds planned for Thursday could also suffer after panic selling by the country's leading banks on Monday prompted a sharp fall in the price of the 10-year benchmark bond.
Source: Financial Times

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