In the third quarter policymakers continued to devise plans and introduce new rounds of stimulus aimed at supporting growth and returning markets to normalisation.
Global economic data has continued to deteriorate, adding credence to the argument that implementing ambitious austerity programmes in a fragile growth environment poses a considerable threat to economic expansion. While it is acknowledged that global bond markets will remain in a relatively low interest-rate environment, it is felt that yields should rise modestly above historic lows.
Additionally, it is expected that increased monetary stimulus by central banks and promised easing in 2013 support a steepening yield curve position in most developed bond markets.
By the same token, exceptionally low long-term interest rates may trigger increased inflation expectations, and thus having some inflation protection in portfolios is advocated. However, particularly in the US, investors should look to add exposure opportunistically given September’s aggressive widening of break-evens post the Federal Open Market Committee’s (FOMC) quantitative easing (QE3) announcement.
As has been the case for more than two years, the European debt crisis will remain a major determinant of price action in global bond markets in the fourth quarter. While Mario Draghi, president of the European Central Bank (ECB), has defiantly stated that the ECB would “do what it takes… believe me it will be enough”, investors continue to be sceptical as European leaders remain largely divided on the best way to contain the crisis.
Political friction between core and the periphery has reached alarming levels, and while the German Constitutional Court allowed the European Stability Mechanism (ESM) ratification to go forward at the end of the third quarter, Germany remains a reluctant participant in bailout efforts.
Moreover, rising social tensions and austerity fatigue in the periphery also serve as downside risks. While the ECB has stated its willingness to engage in further purchases, associated conditionality is likely to raise hostilities even further particularly in light of rapidly deteriorating economic fundamentals.
The idea of ‘Eurobonds’ continues to look like the most credible solution to the crisis, but crafting a remedy that satisfies 17 disparate nations remains a convoluted and time-consuming exercise. Recent months have shown that policy paralysis poses an immediate threat to the survival of the euro in its current form and policymakers can be certain that investors will be eagerly anticipating tangible progress to emerge in the fourth quarter.
In currencies, the impact of potential future reserve diversification flows remains one of the most difficult variables to predict. The shortage of high quality liquid assets denominated in currencies that are not extremely overvalued makes it hard to anticipate how central banks and sovereign wealth funds will deal with their diversification requirements in the future.
