U.S. bond investors have been fleeing European bond markets, as inflation jitters are driving yields on long bonds skyward. A few others, however, believe the sell-off is almost over and are taking a contrary stance.
Some U.S. money managers - notably PIMCO, Prudential's Global Advisors and Putnam - have pulled the plug on their European bond investments. And experts are puzzling whether the markets have stopped their downward cascade.
While it's impossible to get data on recent flows of funds, anecdotal evidence shows U.S. investors retreating to their home market. Among the key signs:
Putnam Investments, Boston, with $8 billion in global bonds, has reallocated to an overweighted position in U.S. bonds, after having had no weighting there earlier this year.
Pacific Investment Management Co., Newport Beach, Calif., reportedly has sold $2 billion in European bonds, on the belief that interest rates had bottomed.
Global Advisors, Newark, N.J., has lowered its weighting in European bonds to 44% from 55%. The firm, a unit of Prudential Insurance Co. of America, runs $3.7 billion in global fixed-income.
Still, others, such as Loomis, Sayles & Co., Boston, have boosted their European bond holdings, lured by attractive yields and values.
The Federal Reserve's interest rate hikes threw global capital markets into turmoil starting in February. Now fears of inflation have battered European bond markets and induced jitters in the bourses.
Increases in yields on long-term European bonds of between 130 and 200-plus basis points since the beginning of the year have compressed what is normally a year-long phase in markets into a period of mere months.
The speed and severity of the changes have caused some to re-evaluate how they look at the markets."The actual behavior, the speed and response of the market, is so much greater than before, it's hard to" understand pricing, said David Shaw, director of bonds and investment strategy at Legal & General Investment Management Ltd., London.
"I'm even tending toward chaos theory now," after living through 20 years of relatively predictable bond-market behavior, he said. Legal & General is undertaking a fundamental review that may lead to changes in how they view bonds.
Clearly, the Fed's tightening of monetary policy precipitated the current environment.
But the growing role of highly leveraged hedge funds, which were forced to sell off their more liquid European bonds; growth in use of derivatives; and the halting of cash flows from overseas into European markets have made the situation much more volatile than in the past.
"In 1993 people wanted long durations. That's why things got so ugly 'cause people had to get out at the same time," said Jeffrey Brummette, managing director of Global Advisors.
In a report, Salomon Brothers International Ltd., London, says the market went overboard last year in discounting disinflation, and the market psychology now has shifted to a highly sensitized fear of inflation.
Sushil Wadhwani, strategist at Goldman Sachs International, London, said: "Market falls can change the way fundamentals are perceived."
The result now is that some market strategists are concluding the threat of inflation is alive.
In a report, Goldman Sachs doesn't find the fear of inflation is justified. A large gap - close to 3% - between actual and potential output for G7 economies, makes it unlikely for inflation to rise. Meanwhile, unemployment in Europe hovers around 12%.
Also, commodities are much less important to the increasingly service-oriented developed economies, Goldman said. Lastly, with the exception of Germany, there are few signs of rampant monetary growth.
Still, sometimes the markets don't believe the economists. "The market is questioning that assumption" (that inflation won't revive), said Terence Prideaux, director, Kemper Investment Management Co., London. What's more, there have been upside surprises in growth figures, Mr. Prideaux added. Those data include recent estimates from the Organization of Economic Cooperation and Development, Paris, which projects industrial economies will grow 2.6% this year.
European bond markets have shown limited signs of decoupling with U.S. capital markets. If the long-term U.S. bond is going down, "the rest of Europe is going down with it," said Michael Lewis, international economist, Morgan Grenfell & Co. Ltd., London.
The lack of decoupling has frustrated many managers."European bond markets should have sold a lot better than U.S.," said Andrea Burke, vice president and portfolio manager of the $25 million New England Global Government Fund. She said Europe has room for lower interest rates because it is barely showing signs of growth. "Interest rates should not have risen (in tandem) with the U.S. There's no fundamental reason," she said.
Those bond markets taking it the worst were the so-called Anglo-Saxon markets - the United States, the United Kingdom, Australia and Canada. The U.K. gilt market was hit hard: bond yields are approaching 9%, while real yields are at 6%.
And things may not improve, as overseas liquidity has dried up. Last year, U.S. investors bought $44 billion of U.K. gilts. While Salomon estimates the U.K.'s borrowing needs this year are dropping to 29 billion from 55.5 billion in 1993, the government still might have to make debt more attractive to domestic investors if foreigners don't fill the funding gap.
Germany has shown the strongest signs of decoupling, as rates have been lowered. But with yields on German bonds now virtually the same as U.S. Treasuries, forecasts on currency became the key decision in asset allocation, explained Jonathan Francis, head of global strategy at Putnam.
In Putnam's case, the manager decided the dollar will be stable to positive, causing it to reallocate assets from European bonds to U.S. Treasuries, although he declined to be specific.
Continental European governments also may be pressed to fund their record budget deficits. Europe governments as a group have a budget deficit of $437.5 billion this year, including $85.1 billion for Germany, $95.8 billion for Italy and $80 billion for France, according to Goldman Sachs. Deficits will top 6% of gross domestic product in many European countries this year, Salomon warned.
All the same, Salomon fixed-income strategist Richard Noble said interest rates will continue to decline. The German repurchase rate has room to drop to 4.5% from 5.1%, he said.
Some money managers share that optimism. Robert Sinche, senior vice president of Alliance Capital Management, said: "We're probably in the final stages of a sell-off in European bonds." He added that comments from European central bankers about inflation coming down in Germany create a better opportunity for European bonds down the road.
"We could get up to 20% overweight in (Europe) in the next couple of weeks by shifting out of the dollar bloc markets" of the United States, Australia and Canada, he said. In the first half, Alliance's portfolios were overweighted 10% to 15% vs. the Salomon Brothers global or international indexes.
Others are downright bullish. John DeBeer, vice president of Loomis, Sayles & Co., Boston, who oversees $330 million in global fixed income, has two-thirds of his portfolios in Europe.
Since late March, he gradually has been increasing exposure and extending durations on European holdings mainly at the expense of Japan, which it no longer holds. At year end, he had as much as 80% in Europe but the figure was reduced to 60% by mid-March.
"Europe is extremely attractive. ... We like real yields and good values. We think the values are excellent and are well prepared to wait. The yields are over 9% in many countries," he said.
But Goldman Sachs officials say that while a European bond rally is possible, the markets still are tied to U.S. economic activity. "Until the U.S. economy is clearly slowing down, it's hard to perceive having any sustainable rallies," Mr. Wadhwani said. "The risks are more on the downside than the upside."