June 1, 2008 / 3:06 PM / 10 years ago

Bond sell-off in focus

LONDON (Reuters) - Investors will be closely watching bond markets this week after a sharp sell-off that has raised the prospect of higher borrowing costs for governments, companies and, ultimately, consumers.

At the same time, markets will be hoping for new guidance on the state of the world economy — with a focus on lagging growth and rising inflation — with a raft of central bank meetings, economic outlooks and key data.

These culminate on Friday with the monthly U.S. jobs report for May, a pointer to everything from economic growth to consumer sentiment and interest rate expectations.

It is the bond market, however, that should grab most of the limelight, particularly at the beginning of the week.

After months of benefiting from safe-haven investment flows, government bonds turned tail at the end of May, sending their yields jumping higher as prices dropped.

Citi’s world government bond yield, a composite, hit its highest level last week since October, while the 10-year U.S. Treasury yield jumped to a five-month high and euro zone government yields reached heights not seen since July.

At the same time, various government auctions of new bonds have been poor, notably in the United States and Germany, indicating depressed demand.

“It is a delicate moment for bond markets,” said Ken Adams, head of global strategy at Scottish Widows Investment Partnership. “The extent of the (yield) rise has been very rapid. You have headline inflation in the developed world rising at clip.”

Inflation — or at least the fear of it — is the main driver behind the sell-off because it makes holding on to low yielding paper less attractive.

And with oil and other commodity prices soaring, expectations that global inflation could reach two-decade highs are rising.

Morgan Stanley, for example, expects U.S. headline inflation to top 5.5 percent from just under 4 percent while inflation in the 15-nation euro zone surged back to 3.6 percent in May, the highest level in the currency bloc’s near-10 year history.

SPILLOVER

If the sell-off continues into this week and beyond, the initial beneficiary could be equities as investors switch from fixed income to stocks.

A Reuters poll of leading investment companies across the world showed last week that this shift is already underway. Equity allocations hit their highest level of the year in May while bonds slipped.

But over the longer term, any such move would be dependent on whether yields continue to rise because of inflation or because of global economic recovery.

Inflation would usually mean higher interest rates, adding to consumer angst and corporate costs, not good for either stocks or bonds. A recovering economy, however, could keep stock markets buoyant.

Separate meetings of the European Central Bank and the Bank of England on Thursday should give a steer to current policy maker thinking on this.

Neither bank is expected to move on rates. All of the 82 economists polled by Reuters last week expected the ECB to remain on hold <ECB/INT>, while only two of 71 saw the Bank of England cutting rates in the face of a declining economy <BOE/INT>.

So focus will be even more than usual on anything that might be said about the inflation and growth outlook.

“Both have been very guarded on inflation prospects,” said Michael Metcalfe, head of global macro strategy at State Street Global Markets.

ECB rates are at 4.0 percent and the BoE is at 5.0 percent. The U.S. Federal Reserve, by contrast, has tended to put growth worries first and has cut rates sharply to 2.0 percent.

OUTLOOK

As for the overall economic climate, investors will get a new view from the Organisation for Economic Co-operation and Development (OECD) when it releases its influential, twice-yearly economic outlook on Wednesday.

In March the OECD said U.S. economic growth was grinding to a halt, that Japan was flagging but that the euro zone was faring relatively well.

It also sounded an early alarm about growing inflation, saying the ECB should not lower interest rates and that the Fed should tread carefully. This was before the huge price spike that has taken oil as high as $135.09 a barrel.

What the latest report says remains under wraps, but it is clear that the OECD is sensitive to growing inflation pressures.

Last week, in a joint report with the United Nation’s FAO food agency, it warned that food prices were likely to remain high for the next decade.

A weaker-than-expected projection for the developed world or its key constituent countries could reignite safe-haven flows back to government bonds.

Similarly, however, more warnings about inflation would be likely to underpin last week’s sell-off.

In the meantime, stock, bond and currency investors will all be gearing up for what is becoming one of the world’s most watched economic indicators — the monthly U.S. non-farm payrolls, or jobs, report.

As a snapshot of how the world’s largest economy is faring, it has little competition.

“The payrolls reports do tend to set the tenor for the next month’s releases,” State Street’s Metcalfe said.

Editing by Christopher Johnson

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