I continue to think stagflation is the greatest risk in the US (see post I linked to)- so I thought I'd post this article, since it agrees with what I think :-) And I think it also jibes with your opinion, Dale, that EU investments are a good bet right now:
Global Fixed Income Economics
Steeper Slopes Ahead
April 03, 2007
By Joachim Fels
US curve disinverts. The US yield curve has steepened significantly since the FOMC meeting on March 21, when the Fed softened its language. For the first time since last August the yield curve is positively sloped, as 10-year Treasury yields rose back above 2-year yields. In my view, this was only the beginning of a more pronounced yield-curve steepening trend, not just in the US but globally.
Inflation is back in play. Two factors should push bond yields higher. First, I expect inflation to surprise on the upside. Globalization is no longer disinflationary, wage pressures are intensifying, capacity utilization is high, oil prices have backed up, and protectionism is making a comeback. With a long delay, we are now receiving the bill for super-expansionary monetary policies in the first half of this decade. Bond investors hate inflation. They will demand higher compensation.
Big buyers of bonds look elsewhere. Second, central banks in Asia and the Middle East, who have used US and European Treasury markets as parking lots for their swelling reserves in recent years, are starting to diversify into riskier assets such as equities. Thus, the bubble in bonds will eventually deflate and, possibly, move elsewhere. Economic fundamentals such as growth, inflation and short rate expectations should reassert themselves as the main drivers for bond yields.
US - goodbye Goldilocks, hello stagflation. I expect the stagflationary US environment of below-trend growth yet sticky inflation to dominate for some time. The reason behind this unpleasant mix is the slowdown in productivity growth. The Fed is thus stuck between growth and inflation concerns and therefore, as our US economists Dick Berner and Dave Greenlaw expect, likely to sit on its hands. This is similar to what the ECB experienced during the European stagflation in 2001-05. Stagflation makes for a steeper curve, but the US steepening should be a bearish one as the Fed is unlikely to cut rates any time soon.
Goldilocks arrives in Europe. Accelerating productivity growth and increasingly better-functioning labour markets make for a more favourable mix of stronger growth and lower inflation in many European countries. This is most apparent in small economies such as Sweden, Switzerland and Norway. But the euro area and the UK also seem to be moving in this direction. Thus, solid growth is less inflationary than it used to be, and central banks need to worry less about inflation. The message hasn't fully arrived at the ECB yet, which looks likely to tighten at least once more. But short rates elsewhere in Europe are likely to rise by less than markets now anticipate. There, yield curves are likely to steepen from the front end.
Bottom line - I'm short bond duration, but less so in Europe than in the US, where inflation risk is looming larger. Consequently, I like TIPS. Moreover, I expect global yield curves to steepen - with the notable exception of Japan, where a more determined Bank of Japan could normalize rates faster than the markets expect.
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