Feb. 2 (Bloomberg) -- After rising in tandem for much of 2006, bonds and equities are starting to diverge, to the detriment of some sections of the fixed-income markets in the first month of the year. It might not last.
In January, the Standard & Poor's 500 Index of U.S. stocks eked out a 1.4 percent gain, while Europe's Dow Jones Stoxx 600 Index climbed 2 percent. Fixed-income returns, meantime, are a sea of red, with U.K. bonds maturing in more than a year losing 1.5 percent. Euro-area debt has fallen 0.4 percent and the U.S. futures contract on long-dated bonds more than a point.
The bond market is rediscovering reasons to be concerned. U.S. consumers haven't taken fright at the parlous state of the housing market and fled screaming from the shopping malls. The Federal Reserve isn't about to start cutting interest rates. So far, the inverted yield curve, with two-year note yields higher than 10-year levels, doesn't seem to be a harbinger of recession.
The U.S. economy grew at a not-so-shabby annual pace of 3.5 percent in the fourth quarter, according to figures this week, faster than the 3 percent anticipated by economists and up from the third quarter's 2 percent pace.
``The battle between bonds and equities to decide which asset class better reflects the U.S. growth outlook appears to be swinging decisively toward equities,'' Tim Drayson, an economist at ABN Amro Holding NV in London, said in a note this week.
The Fed sweetened its assessment of the economy at this week's policy meeting, describing ``somewhat firmer economic growth.'' That was a change from ``economic growth has slowed over the course of the year'' outlined in December. It certainly doesn't sound like a central bank about to ratify economists' expectations for a bond-bolstering rate cut.
Seduced by Debt
Meantime, governments are flooding the market for long-dated bonds; regulators are increasingly vocal about their concerns that the derivatives market is an opaque accident waiting to happen; and even some of the people who depend on the credit market to finance their businesses are hitting the klaxons.
Sovereign borrowers are being seduced into the long end as the relative cost of selling 30-year debt rather than two-year notes has melted.
Two years ago, for example, Germany would have paid about 1.8 percentage points more to extend its borrowing. The average gap between two- and 30-year German government bonds was 80 basis points in the first half of 2006, and about 60 basis points for the year as a whole. Today, the relative difference is down to about 26 basis points, or hundredths of a percentage point.
Germany, Greece, Austria, the Netherlands, France, Turkey and Italy sold almost $24 billion worth of 30-year debt in January. Japan sold 600 billion yen ($5 billion) of 30-year bonds, while France also borrowed 1.2 billion euros ($1.6 billion) for 50 years.
Taking Advantage
``We expect a huge increase in 30-year European government bond issuance, up 55 percent to 66 billion euros, as finance agencies take advantage of the flat yield curve,'' Luca Cazzulani and Kornelius Purps, analysts at Milan-based Unicredit, said in a research report last week. ``Most of that supply should be delivered during the first half of 2007.''
There's more to come. The U.S. plans to sell $9 billion of 30-year bonds on Feb. 8 in its quarterly refunding program. The U.K. plans to issue 2.25 billion pounds of bonds repayable in 2046 on Feb. 6. Brazil plans to add to the $1.5 billion of 30- year dollar bonds it first sold a year ago, Spain is considering a benchmark 30-year bond in the first half of this year, while Greece is mulling its first 50-year bond.
Namibian Debt
Even lower-rated borrowers found long-dated debt buyers in January. Namibia sold 40 million Namibian dollars ($5.6 million) of 17-year bonds, Colombia issued 400 billion pesos ($177 million) of inflation-linked debt repayable in 2023, while Indonesia borrowed 4.8 trillion rupiah ($528 million) for 20 years.
In the latest of many warnings from regulators about complacent financial markets, Bank of England Deputy Governor John Gieve told the U.K. Parliament's Treasury Committee yesterday he's concerned that the robustness of the credit- derivatives market hasn't been tested.
``The opacity that worries me is that there are a lot of new instruments and new players, and we don't know whether the patterns of correlation that people are trusting, that have held up over the last five years, would continue to hold up in future,'' he said.
That echoes comments made last week by Steven Rattner, co- founder of buyout firm Quadrangle Group LLC. ``The world isn't pricing risk appropriately,'' Rattner said. ``Spreads are the narrowest they've ever been. Investors are simply not being paid for the risks they're taking.''
Regulators, though, are paid to worry, no matter how unspecific their concerns are. Rattner is unlikely to turn down cheap finance for his next deal, no matter how imprudent he judges his lenders to be.
Pockets of Resistance
And pockets of the bond market remain resilient. Europe's market for non-government debt had its best day in at least six months yeterday, as a benchmark index of credit-default swaps showed the cost of buying insurance against companies failing to pay declined more than 3 percent.
While government bonds got into a bit of a funk last month, the credit markets continue to suggest that the outlook is for a just-right Goldilocks economy, not too hot and not too cold.
So before you reach for your furry suit, remember that every time the bond bears have started packing their hampers for a celebratory picnic in the past few years, they have had the rug pulled out from under them.
(Mark Gilbert is a Bloomberg News columnist. The opinions expressed are his own.)
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