International Bond Market Update
Are happy days really here again or will today's green shoots become tomorrow's wilting stems? While there is undisputable evidence that economies in most parts of the world are stabilizing—and some are even showing modest signs of recovery—we believe that the markets have started to become complacent about the challenges that lie ahead. The projected pace and sustainability of the economic recovery is still very much in question. The picture gets even muddier in Europe, where key elections are to take place in Germany, and the United Kingdom, where U.K. Prime Minister Brown is hanging onto power by a thread.
The global bond markets continued to outperform the U.S. market in relative terms but were unable to escape re-pricing, courtesy of supply-related concerns and reignited (and in our mind overblown) inflation fears. Higher yield levels attracted buyers in all market segments. Contrary to initial fears, and undoubtedly aided by rising consumer savings rates here and abroad, there was a significant appetite for bonds on a global level as long as they were priced attractively. Key interest rates will likely remain on hold for the foreseeable future, occasional rhetoric notwithstanding, as the European Central Bank (ECB), the Bank of Japan (BOJ), and the Bank of England (BOE) are not positioned to seriously contemplate any tightening of their respective monetary policies. It is prudent, however, to expect the conversation about neutralizing this unprecedented global liquidity injection to gain momentum going forward. We believe that the Europeans will ultimately take the lead in formulating and implementing an exit strategy, though their economic recovery clearly trails that of the United States.
The BRIC nations (Brazil, Russia, India, and China) did their best to rattle the markets by sending the world mixed signals with respect to the reserve currency holdings in U.S. dollars. Are they putting their money where their mouth is? It does not appear to be that way. For example, take China, the largest holder of U.S. Treasury debt. One might argue that this nation whose current account surplus is on target to reach an excess of at least $360 billion (versus $423 billion in 2008) by year end 2009 will have little alternative but to continue to invest in the U.S. securities market. Recent Treasury auctions show no decrease in interest from overseas investors.
There is a discussion about adopting the Special Drawing Rights (SDR) issued by the International Monetary Fund (IMF) as the primary reserve currency, but it is largely an academic one, as it is neither imminent nor practical at this juncture. SDRs are relatively-narrow currency baskets, currently consisting of 44% U.S. dollars, 34% euros, 11% yen, and 11% pounds sterling. The current composition of the SDRs and, more importantly, the voting shares at the IMF are reflective of the historic balance of power within the IMF at its creation.
In our mind, the real issue at play is that BRIC nations and countries like Mexico should justifiably have power more reflective of their current economic might. As it is, the oil rich nation of Mexico has fewer votes (1.43%) than the Kingdom of Belgium (2.09%), and the United Kingdom has more votes (4.86%) than China (3.66%), the third largest global economy. We believe that the intermittent goal of the BRIC nations is one of gaining acceptance and influence, which is being addressed via investing a relatively small part of their excess reserves in SDR-denominated instruments of the IMF, rather than that of replacing the U.S. dollar as a primary reserve currency. While Europeans might like the idea of the euro taking on that role, even they must concede that in its current legal structure, the euro-zone is ill-equipped for such a challenge. In the long run, we do expect that the U.S. dollar's position as the undisputed reserve currency will be challenged, but we believe that time has yet to come.
Not all is well in the euro-zone, Great Britain, and Japan. We expect that their respective economic recoveries will lag, and that lag will be particularly significant for Europe and Japan. We believe this will support the dollar in the short run, but over the long term the United States will have to pay the piper as it faces the reality of an undisciplined and unsustainable budget deficit. As a result, our long-run view is bullish on foreign debt denominated in euros and other currencies relative to U.S. dollar-denominated debt.
- Interview with Frank Koster, CIO
- Fixed Income Sector Review
- Economic Update
- International Bond Market Update
- Dwight News
- Investment Performance
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