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Eurozone Troubles Make US Bonds Look Cheap

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Investors are looking at the relative rather than the absolute value of bonds, the co-managers of the Osterweis Strategic Income Fund wrote in their October fixed income outlook, so prepare for lower U.S. yields as European bonds “make U.S. bonds look cheap.”

According to the October outlook for fixed income, 10-year German bonds were at an “all-time low,” falling to 0.9%. 

There are three factors getting lost in investors’ demand for bonds, according to the authors. First, compared to the eurozone, the U.S. economy is in fairly good shape. Second-quarter GDP was up 4.6%, and and the consumer confidence index topped 92. (On Tuesday, the Conference Board reported that the index was 94.5 in October.)

Unemployment is falling as well — 6.1% in August, compared with 7.3% a year earlier, and with 11.5% for the eurozone in July. (The U.S. rate fell even further to 5.9% in September).

Finally, inflation is “modest,” although the authors noted that it’s not likely to stay below 2% for long considering the better-than-expected improvement in unemployment.

They argue, too, that unemployment will keep improving. They cite a retiring population and sharply reduced numbers at U.S. factories as evidence for their belief that “that the job market is closer to the point at which employers will need to increase wages to hire and keep workers.”

Osterweis encouraged Fed Chairwoman Janet Yellen to follow the example of Mark Carney, governor of the Bank of England, who called the U.K.’s current inflation environment “benign. But it will not remain benign if we do not increase interest rates prudently as the expansion progresses,” the authors quoted in their outlook.

Unfortunately, they wrote, “Yellen seems to be comfortable waiting years before increasing rates since she tends to believe that the low unemployment rate overstates the improvement in overall labor market conditions.”

They blamed the financial crisis partially on the Fed’s reluctance to raise interest rates after the recession in the early 2000s, when the federal funds rate was dropped to 1% by June 2003. It stayed there for a year until it was raised by 0.25%. Housing starts had risen sharply beginning in 2002 and continued to do so through 2005.

“We believe that by holding the benchmark rate low while the economy rebounded and bubble conditions in housing fomented, the Fed might have been partially responsible for the resultant banking crisis of 2007-2008. We do hope that the Fed will learn from this and not fall behind the curve on interest rates this time around,” the authors wrote.

The authors pointed to a potential bubble in U.S. government and mortgage securities. These two areas constitute a larger portion of the fixed income market compared to leveraged loans and high-yield bonds, which Yellen called “potentially excessive” in her semi-annual testimony on monetary policy to Congress. “We are also concerned that there are price distortions in U.S. government bonds given that most are now in the hands of lenders of last resort (i.e. the Fed, Japan and China), who are not driven by the normal investors’ profit motive,” they wrote.

Ultimately, current yields don’t make up for the “continuing benign interest rate environment” or provide enough protection against potential interest rate increases in the future, according to Osterweis.

— Check out Time to Follow Bill Gross Into Unconstrained Bond Funds? on ThinkAdvisor.