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US figures trigger fears of a bond market bubble

David Kern

The financial markets have been dominated by rising fears that US economic growth is slowing at an alarming pace. The markets may be exaggerating the risk of an imminent double-dip recession, but US prospects have clearly worsened, triggering mounting concerns that the negative consequences could be global.

US data has been disappointing across many areas: jobs, trade, consumer confidence, retail sales and, most importantly, housing and GDP. The acute housing weakness has been particularly disturbing. Sales of US homes, new and existing, have recorded precipitous declines, reaching multi-year lows in July.

In reaction, risk appetite fell and bond yields plunged to levels that may unleash dangerous bubbles. While some falls were expected, following the earlier expiry of a tax credit for US homebuyers, the scale of the collapse was disturbing. Housing debt was a major cause of the 2008-09 recession and new setbacks could depress further consumer confidence. Renewed house price falls could accentuate pressures on frail banking sectors and heighten the danger of unleashing a new debt crisis.

US GDP growth for the second quarter of 2010 has been revised down sharply, to a meagre 1.6 percent, confirming that the US economy is weakening at a worrying pace. As the markets expected an even worse figure, the news was not sufficiently alarming to trigger an immediate policy response. But since much of the downgrading in US growth was due to a larger trade gap, one unwelcome result could be to intensify the clamour for protectionism in the run up to the US mid-term congressional elections in November.

Developments in Asia reinforce signs of global slowdown and risk adding to protectionist pressures. Japan’s GDP growth fell to an annualised rate of 0.4 percent in the second quarter of the year, much weaker than the 4.4 percent recorded in the first quarter and well below expectations.

Japan’s renewed weakness, which coincided with a surge in the yen, triggered renewed pressure on policymakers to intervene directly in the forex markets for the first time since 2004, in order to curb the yen’s rise and support Japanese exports.

Even China and India, the emerging Asian giants that many regard as the world’s new growth engines, have shown distinct signs of slowing even though their pace of expansion remains very strong by Western standards. More disturbing from a global perspective, China’s trade surplus surged to an 18-month high, while the bilateral US deficit with China now accounts for more than half of the total US trade deficit. These figures are politically explosive in the face of high US unemployment; they threaten to worsen trade tensions and revive accusations that the Chinese yuan remains undervalued.

Europe has been a surprising exception to the darkening global growth picture. Eurozone GDP grew one percent quarter-on-quarter in the second quarter of 2010, the fastest rate in more than three years and much higher than the region’s average growth rate recorded since the euro was established in 1999. However, the strong overall figure masks worrying divergence between robust growth in core northern countries, notably in Germany, and persistent weaknesses in the eurozone periphery. These tensions have prompted new worries about fiscal deficits, debt and banking sector stability. Ten-year yield spreads of Greek and Irish government bonds, over German bonds, have widened again considerably, signalling new fears of sovereign default.

In the UK, GDP recorded stronger-than-expected expansion of 1.2 percent in the second quarter of 2010. After lagging other major economies in the early stages of the recovery, the UK has outperformed recently both the US and the eurozone as a whole, though UK second-quarter growth was not as strong as that of Germany’s 2.2 percent. But the UK economy will face serious obstacles from now on, since the tough deficit cutting programme that will be implemented over the next few years will dampen demand significantly. Risks of a UK economic setback remain serious.

In the financial markets, weaker US growth and reduced risk appetite have over­whelmed Europe’s strong performance. The result was a flight to safe assets, mainly government bonds of core economies. The 10-year US yield plunged below 2.5 percent, its lowest level since January 2009, while 10-year German and UK yields dropped to their lowest levels on record.

These unprecedented falls point to a bond market bubble, which may cause serious problems when it bursts. But, if the bond markets point to new realities, the message they convey is more ominous; they may signal potential threats of deflation and stagnation. In the currency markets, the flight from risk pushed the Japanese yen to a 15-year high against the dollar. But the dollar also benefitted, rising against the euro in spite of stronger eurozone growth.

On the policy front, pessimism about growth and plans for fiscal tightening in Europe have reinforced pressures on the main central banks (US, eurozone, UK and Japan) to persevere with very expansionary monetary policies.

As well as keeping official interest rates at their current exceptionally low levels until the second quarter of 2011 at the earliest, there is a growing prospect that the US Federal Reserve and the Bank of Japan will soon increase their quantitative easing programmes, so as to avert the risk of setbacks.

David Kern is chief economist at the British Chambers of Commerce. He was formerly NatWest Group chief economist

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