Global government bonds:
Light at the end of the tunnel

Now that we know the size of the problem, it's easier to look into the future. If anything, 2008 was dominated by working out exactly what was going on in the global economy. We spent a lot of time debating the extent of the credit crunch and whether it would have real economic effects, rather than just being something that should concern a couple of technicians squirreled away in financial companies around the world. The implosion of the banking system and the rapid decline of the real economy in the second half of 2008 answered that question.

The last hurrah

Global government bond yields have responded as you would have expected, by declining to all-time lows in some instances. However, the real battle in 2009 will be between the opposing forces of faltering economics and the need to issue unprecedented amounts of public debt to finance the economic support packages.

The US is, of course, a case in point: there is a definite need to reduce benchmark bond yields so that mortgage rates can be lowered. At the same time it appears more than likely that the US$700bn of the world's money which the US Congress awarded itself won't be enough and that figure will rise under the newly-elected President Obama. In order to coax US bond yields downwards, the last desperate act in a series of increasingly desperate acts may yet see the US authorities engage in wholesale manipulation of the bond markets (known as 'quantitative easing') to drive yields down to artificially low but economically necessary levels. Other government bond markets may be drawn into the US yield declines. In that sense, western bond yields will converge towards their Japanese counterparts as part of the last great rally in the 27-year bond market rally which has been ongoing since the early 1980s.

Time is a healer

Bond markets are tremendously good at looking through the immediate and into the future and whatever happens in the conventional government bond markets in 2009 there are already signs of the opportunities which will form the policy of the future (see chart).

While the gloom surrounding the global economy has intensified, corporate bond yield spreads have ballooned outwards to levels well above anything rational. At the same time the western inflation-linked markets have inflation assumptions built into them that imply that price rises will be, on average, negative or near zero for the next five to seven years. These pessimistic extremes are well-founded given the data currently emerging, but at the same time contain assumptions which are wholly inappropriate in open capitalist systems. There will be a process of healing and reconstruction to go through, but it is a process and not a life sentence, and the corporate bond/supranational bond/inflation-linked bond markets look like good medium-term investments which should form part of any portfolio in 2009.

Unstable ground

Finally, there is the currency conundrum. The US dollar surprised us by appreciating strongly in 2008 but this was more due to a technical shortage of currency than a positive vote about the virtues of the 'greenback'. With economies struggling around the world and still much to emerge from the cleaning up of financial companies, the process of sorting out who constitutes the 'best of the worst' has some way to go. Of the two 'at risk' currencies, the US dollar and sterling still come out as the most vulnerable due to their chronic dependency on other people's money to fund their economies.

A single slip in the funding program or the intimation that international investors are not prepared to fund their deficits, and the demand-hungry currencies will have the support pulled from underneath them. The euro and the yen come out as favourites in that sense with the yen probably still edging the vote for the time being. Commodity currencies won't see any recovery until more conventional thoughts of sustained stability become apparent - this will be a story for late 2009.