The outlook for 2012 is uncertain, to say the least. But as of now it seems that the Eurozone has entered a mild recession and that there is a growth slowdown in Asia. In the US economic activity is picking up, but a slowdown in the global economy might well affect the US too. Rather slow economic growth seems to be in store, but we might be surprised of course, both on the upside and the downside. The downside risk that might materialize is the Eurozone sovereign debt crisis escalating to a financial crisis.
I think it is fair to say that this rather gloomy perception of the near future is priced into financial markets. Long-term bond yields in countries with their own central bank are lower than expected inflation, and short term sovereign bond yields are now negative in some markets.
Assuming slow economic growth, there are two scenarios for long-term nominal interest rates in advanced countries with their own central bank. Meagre investments and a continuation of the near zero interest rate policy might lead to deflation and even lower long-term yields, as has been the case first in Japan and then in Switzerland. But slow growth implies continuing high public deficits and an acceleration of the public debt in most advanced nations. This could lead to a loss of faith in public finances, with much higher nominal interest rates and eventually significantly higher inflation. We think the probability of the latter outcome is greatly underestimated.
There is also definitely the possibility that growth could surprise on the upside. That would lead to higher long-term nominal interest rates through an increase in the underlying market clearing real interest rates.
In some emerging economies with solid public finances there is room for a significant fall in long-term sovereign yields. Convergence between advanced and emerging economies when it comes to sovereign yields will, we think, be a theme for 2012 and beyond.
The Economy at a Glance is a monthly macroeconomic update from portfolio manager, Torgeir Høien.
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