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No more Mr Nice Guy

After a decade of non-inflationary, consistently expansionary economic growth, the future is more uncertain

Not long ago, rising energy costs were being used to justify low bond yields on the basis that they would cause economies to grow more slowly. Now investors appear more concerned about the inflationary consequences and are demanding higher bond yields as compensation.

The tragic and disruptive impact of Hurricanes Katrina and Rita initially caused analysts to downgrade their forecasts for US and global growth in the second half of the year. There was even the short-lived expectation that the Federal Reserve might pause in its steady tightening of monetary policy. However, sentiment changed as the Fed hiked rates and investors turned their attention to the possible benefits of rebuilding the affected areas. The response has been for US yields to move higher and the price of US bonds to fall.

In the UK last week, the Bank of England’s monetary policy committee left interest rates unchanged at 4.5 per cent but this has not dented market expectations that the next move in rates will be up to 4.75 per cent. Yields on UK Government bonds have been struggling to rise with as much gusto as their European and US counterparts. Yields of 4.4 per cent on 10-year gilts do not compare favourably with base rates at 4.5 per cent, let alone 4.75 per cent, especially once you factor in uncertainty in the ability of central bankers to keep inflation under control over the next 10 years.

In the US, the Fed funds rate has risen steadily from a 1 per cent low in June 2004 to 4 per cent. With 10-year US government bonds yielding 4.6 per cent, the compensation appears to be greater than that on offer in the UK. But when you consider that the market expects US rates to continue upward towards 4.75 per cent in the first half of 2006, it appears likely that 10-year US bond yields will have further to rise from here.

As yields on cash and government bonds rise, the rewards for investing in more risky assets look less appealing. The extra yield available from investing in non-government bonds remains at historically low levels. Holding your average US AA-rated corporate bond earns you almost 0.6 per cent more in yield than its government equivalent. But given that this was little different when interest rates were only 1 per cent makes the compensation for credit look less rewarding.

There is also the danger that the risks associated with holding corporate bonds may be rising. Private equity funds have attracted unprecedented levels of sponsorship and are responsible for a rising number of leveraged buyouts and consequent credit rating downgrades – an additional danger for your average investor.

The challenges for fixed-income investors are similar to those faced by central bankers around the world. How will economies react to higher energy costs over the medium term? Will China’s economy continue its dizzy- ing rate of growth consider- ing it depends on export growth? Should inflation targeting be the only measure of a central bank’s success? Have easy credit and low borrowing costs left consumers more vulnerable to rising rates? For how long will the migration of work- ers from Eastern Europe to Western Europe keep a check on rising wage pressures?

It was Bank of England governor Mervyn King who tagged the past decade as the “nice” decade, a period of non-inflationary, consistently expansionary economic growth. Whether this has been more down to luck than judgement is debatable. The future is uncertain and that can be an opportunity, provided you are adequately compensated for it.


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