20 December 2001, 14:30  OUTLOOK Euro zone bonds set to firm further in 2002, at least for a few months

--- by Pan Pylas --- LONDON (AFX) - European government bonds look set to strengthen further next year, at least in the first few months, before a bear market grips on the back of economic recovery, according to most strategists. The timing of the turn will depend on the speed of the recovery in the US and in equity markets, together with what goes on with oil prices, but most do not expect anything substantial to occur until the second quarter of 2002. "I can't see the beginnings of a bear market," said Rob Carnell, a strategist at Commonwealth Bank of Australia. The European Central Bank has room to cut rates further from the current 3.25 pct, with most economists expecting at least another 50 basis point reduction in the early months of next year. Barclays Capital strategist Jon Lee says rates could hit 2.0 pct if the ECB is slow to cut rates again, thereby lengthening and deepening the downturn. However, he remains quite bearish about bond markets in Europe, even though the European recovery will lag the US by around five to six months. "Once the seeds of recovery have taken root, then we will enter a bearish period for bond markets," he said. But when those seeds have taken root, the ECB should ease monetary policy more than currently anticipated by the markets, according to Cesar Molinas, chief European debt strategist at Merrill Lynch. "This should take short-term yields back to the 3.0-3.1 pct area," he said. "This decline should also bring about another rally for long-term government bonds in the first part of 2002." The catalyst for further rate-cutting, said Molinas, will be sustained lower-than-anticipated inflation in the euro zone. Inflation, he said, could even reach the 1 pct level by the middle of next year if oil prices remain at current levels. "A 2.75 pct (rate) trough next year looks likely to us," said Molinas. "Fair value for two-year German yields would lie around 3.1 pct." Commonwealth Bank of Australia's Carnell also thinks that rates will trough at 2.75 pct, as euro zone inflation dips to at least 1 pct. "I'm still a bit sceptical about a recovery, though the rate of decline is easing and the data is mixed," he said, "and everything boils down to what the US does." However, by the middle of the year, strategists expects a front-end driven bear flattening in the yield curve as the global economy begins to show signs of recovery, on the back of the monetary easing around the world, the fiscal stimulus in the US and the relative weakness in the oil price. "Because of the usual lags of the ECB, this process may lag in Euroland relative to the US as it was the case in the first half of 1999," said Molinas. A relatively flat yield curve is also likely to be sustained by stability in the bond issuance markets and the desire of euro zone countries to reduce their debt's average duration.

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