Steepening yield curve points to further pain

While rate cuts are good news for short-dated bonds, spreads on long-dated bonds will continue to widen, says Amstad at Aberdeen Asset Management.
Donald Amstad, head of fixed-income at Aberdeen Asset Management, expects Asian currencies, equities and credits to ourperform their US and European peers in 2008.

The company is broadly overweight on most Asian currencies and remains optimistic on the long-term prospects of Asian equities. However, Amstad expects further short-term rate cuts in view of worsening economic conditions, which in turn will lead to yet more increases in the cost of long-term borrowing rates.

ôThe reasons for a relatively rapid deterioration in the global macroeconomic outlook are two-fold,ö says Amstad. ôWe are witnessing the bursting of two bubbles simultaneously: the first is the US housing bubble, with house sales and prices falling sharply; and the second is the credit market bubbleö.

Until now, the market for credit was ôturbo-chargedö thanks to the growth of the synthetic CDO (collateralised debt obligation) market. Due to subprime problems, the CDO market has collapsed, leading to a dramatic widening of bond spreads.

ôAgainst this backdrop, the Fed has moved very quickly with enormous rate cuts over the last few months. However in the US bond market for example, the 10-year government bond yield has increased from 3.27% on the day of the latest cut, to 3.6% today,ö continues Amstad. This means that despite short-term interest rates coming down, long-term interest rates are rising - in other words the yield curve is steepening.

AmstadÆs view is that the yield curve will continue to steepen in the US, Europe and the UK. ôWhile the rate cuts are good news for short-dated bonds, spreads on long-dated bonds will widen further. ItÆs too early for us to enter the markets.ö

Moreover, while a steep yield curve is necessary to re-capitalise the banking system, the Fed also needs to stimulate the mortgage market, which is linked to the 30-year US Treasuries yield. But rising long-term yields will exacerbate the problems in the US housing market.

Nonetheless, Amstad is relatively optimistic on the outlook for Asia and expects Asian credits to outperform their US and European peers given that Asian companies are considerably less leveraged. Aberdeen is also broadly overweight Asian currencies. ôMoreover, on the equity side, we find companies with value much easier to find in Asia than in the US or Europe,ö he concludes.
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