It's a dog's life

A prerequisite of a recovery is the need for indebted peripheral European economies (in the absence of a large currency devaluation) to have access to low borrowing costs while they adjust their fiscal balances. Suggestions to lower lending rates to those countries that have sought funding (Ireland, Greece and soon Portugal) would be a step in the right direction.

Talk of expanding the size of the EFSF (European Financial Stability Facility) is premature as the facility has barely been tapped, but suggestions that it might be used to buy secondary bonds could be very important when trying to draw a line ahead of Spain. If the only countries supported directly by the fund are Ireland and Portugal, then extension of financial aid to Spain via secondary bond purchases might be possible. Support of the Spanish market by ensuring lower bond yields prior to the point of crisis may enable the EU to cut the size of the eventual bill, but those off ering the aid, and particularly the International Monetary Fund and Germany, want to see real structural and fiscal reforms. Such reforms could be enforced as a condition of formal aid, but will not necessarily be achieved solely by lowering the miscreants' borrowing costs.

Even if those in a lesser plight adopt a more flexible approach, this still leaves the enormous task of deflating large parts of the eurozone economy through fiscal adjustment and wage declines, while providing sufficient liquidity to their respective banking systems during the process. Europe has moved a step closer to re-structuring the debt of the smallest and weakest peripheral markets. Given current prices we would suggest that the market has priced this in for Greece but has yet to do so for Ireland and Portugal. A European Central Bank that, in accordance with its mandate, worries about its inflation-fighting credibility and sounds hawkish during a temporary spike in headline eurozone inflation, could derail recovery if it chose to raise interest rates prematurely.

A cautious reduction in our already underweight periphery exposure seems appropriate, but a lack of clarity remains.

Meanwhile, the other major government bond markets have also been challenging for investors. Our previous suggestion that the US 10-year bond would trade within a broad yield range of 2.5% to 3.5% seems to be holding for the time being, and yields have risen towards the top of that range since the Federal Reserve embarked on its second round of quantitative easing, "QE2". We expected speculation over QE2 to push yields up to 2.5%, and then that a revival of economic growth would push yields back up to 3.5%. Given the sharp declines in price since the announcement of QE2, we must question whether yields will break out of the top end of this range. If growth continues to be positive, then a spike towards 4% is possible, but higher yields (and some have called for a normalisation towards 6%) seem unlikely while unemployment remains high and the housing market is still very vulnerable.

The stable relationship between 10-year US yields and long-term mortgage rates suggests that any further decline in bond prices will result in an unwelcome return to post-crisis mortgage rates. Once the housing market crisis was underway, the mortgage rate dropped to an average of 4.7%, compared to the pre-crisis level of 6%. The US housing market seems to us to be just as unstable now as it was 18 months ago, and higher mortgage rates would be detrimental to stabilisation. Assuming a gap of 1.25% between mortgage rates and the 10-year yield, it can be supposed that the 10-year Treasury market would stay within its recent yield range. Clearly the US economy is on a recovery path, but it remains fragile. For now, we would dismiss the '6% normalisation' levels being suggested by some in the market, but short-term noise about the high deficit and a flow into risk assets (equities) could test the upside of the yield range for a while longer (see graph below).

Higher headline inflation owing to rising energy and food costs can be expected in the coming months. Previous energy-related increases in headline inflation may prove to be temporary, and do not always lead to higher core inflation; amid very low wage growth and high unemployment during the debt deleveraging phase, this may be the case. Inflation-linked securities that are priced from headline inflation and are not derailed by a falling conventional bond market have the potential to perform well in this environment.

The Greek riot dog should be adopted as a mascot for all European bond investors, as his determination in the face of considerable uncertainty is an example to us all. Perhaps US Treasury investors may need a similar mascot, going forward.