Bond market vigilantes – they’re back!

• Not since the early part of the 1970s has there been quite so spectacular a boom in commodity prices. Today’s boom, like that of the 70s, reflects the growth under way in the global economy though we’re talking about growth in the developing world, which is the key driver behind raw material prices and metals prices in particular.
  
  
• It’s also the driver behind the prices for foodstuffs, e.g., wheat, corn, sugar, among other things, including hogs. But pressure on soft commodities is also coming from the biofuels industry. Although higher commodity prices should curb the demand for feed stocks, biofuel production is widely supported by government subsidy and therefore, higher commodity prices might not have quite the effect on feed stock demand they would otherwise.
  

• Booming commodity prices are a risk for inflation. For a start they affect costs and squeeze profit margins. Producers attempt to pass on costs. For consumers, relative prices are affected initially but if their purchases constitute a significant share of the overall basket of goods and services, a rise in the general level of prices reduces real wages. The attempt by labour to claw back any loss in real wages raises costs, squeezes profit margins further and so on. What happens ultimately to inflation depends also on productivity, where pricing power lies and, course, central bank policy. It’s never so simple.
  

• Rising commodity prices say more about the strength of the global economy than they do about inflation. There isn’t an inflationary problem - yet - but there could be if growth in the global economy is left unrestrained. That is the message government bond markets have left behind this month. If the increase in yields has meant anything, it is that the tightening bias in central bank policy needs to be retained. Fed Funds futures may discount lower interest rates but, so long as the trends in the chart point upward, rates aren’t coming down.
  

• Central bank mandates vary, but broadly, policies have been geared to normalizing interest rates i.e., raising them to levels deemed appropriate to sustaining non-inflationary growth. The issue now is whether interest rates need to be raised much beyond the boundaries of normalization.
  

• Our view is they don’t. We expect the Fed to keep policy on hold for the time being and to retain its tightening bias. Like the Fed we view the risks to be on the upside for inflation. In the UK, another quarter point hike is likely and possibly another after that though we are beginning to feel that the MPC has taken interest rates up enough and that there is a pain barrier at 6 percent. In the eurozone we see a maximum of 4.5 percent in the main refinancing rate before the ECB puts policy on hold.
  

• That said, corporate bond markets are likely to be the best judge of the interest rate outlook. Yields spreads tend to be driven by default risk and default risk tends to rise with interest rates. Yield spreads have widened over the past month but remain historically narrow.
  

• Nevertheless a switch out of the lower quality end of the corporate bond market into higher quality issues seems appropriate. The strength of the global economy should sustain earnings growth and that should support the quality corporates.
  

• Strong global growth should also support equity markets which remain satisfactorily valued. However, the bond market vigilantes are on the rampage and that means equity markets aren’t likely to get anywhere. They’ll trade up, they’ll trade down, they’ll trade sideways, which is what they’ve done this month.
  

• Our guess is that the bond market vigilantes will want to freshen up some and will head back to the saloon. Government bond markets are oversold and the US Treasury market has been rebounding. At current yields we feel gilts offer a buying opportunity. They’ve priced in a quarter point hike in base rates at least. The trouble is it won’t take much to ‘rile’ the vigilantes and they could soon be saddling up again.
  

• That’s the risk for equity markets. In the short term, concern over interest rates is likely to be the dominating influence. However, the fundamentals remain supportive and we suspect that the underlying trend in equity markets will remain upwards. There’s risk out there in them there hills, but there’s also reward.

* The information contained in this report has been taken from public sources and is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness. The opinions expressed in this document are not the views held throughout Brewin Dolphin Securities Ltd. No Director, representative or employee of Brewin Dolphin Securities Ltd. accepts liability for any direct or consequential loss arising from the use of this document or its contents. We or a connected person may have positions in or options on the securities mentioned herein or may buy, sell or offer to make a purchases or sale of such securities from time to time. In addition we reserve the right to act as a principal or as agent with regard to the sale or purchase of any security mentioned in this document. Prices, values or income may fall against the investor’s interests. You should therefore be aware that you may get less back than you invested. Past performance is not a guide to future performance. If you are in any doubt concerning the suitability of these investments for your portfolio, you should seek the advice of a qualified investment adviser.