Aug. 11 (Bloomberg) -- Bond investors, who little more than a month ago were predicting lower interest rates amid a growing risk of deflation to the global economy, now say the next move by the Federal Reserve, the European Central Bank and the Bank of England will be to increase borrowing costs. ``There's been an absolute U-turn in rate expectations,'' said Rajeev Demello, who manages the equivalent of $5.8 billion in euro-region bonds at Pictet & Cie., Geneva's largest private bank. ``No one expects a cut anymore.''
Not after the U.S. economy, the world's biggest, showed annualized growth of 2.4 percent in the second quarter; in Japan, the No. 2 economy, household spending had its biggest gain in almost two decades in June and in Germany, the third-largest economy, business confidence rose to a one-year high in July. The U.S. economy is now in a ``reflationary'' period that will help avoid deflation and will put the bond market ``on the defensive,'' said William Gross, managing director and chief investment officer at Newport Beach, California-based Pacific Investment Management Co., the world's biggest collection of bond market mutual funds. Gross's colleague at Pimco, Managing Director Paul McCulley, who manages more than $100 billion, said as recently as July 15 that the overnight lending rate among U.S. banks wouldn't rise for another two years. Pimco's $73 billion Total Return fund fell 3.76 percent last month, the largest decline of the 10 best-selling bond funds in the U.S.
Rate Reversal
December futures contracts indicate investors who on June 13 had seen as much as a half-point cut in the benchmark federal funds rate aren't forecasting another reduction. Fed policymakers meet this week to decide on interest rates, with all of the 78 economists polled by Bloomberg News forecasting no change. The Fed will raise rates in the second or third quarter of next year, a survey of 53 economists showed. In Europe, the yield on the three-month Euribor contract for December rose above the three-month money market rate this month, ending almost a year of rate cut expectations. The June contract yielded 2.45 percent at 8:48 a.m. in Frankfurt, suggesting investors predict rising rates by the end of the first half. Investors are betting on a U.K. rate increase by the end of 2003.
What happened? Demello said he started selling German 10-year government bonds after Fed Chairman Alan Greenspan on July 15 said growth will accelerate without the bank resorting to purchasing government securities. Those comments came just three weeks after the Fed cut its benchmark rate from 1.25 percent, and six weeks after Greenspan told a conference in Berlin he would ``lean over backward'' to avoid deflation.
Bond Rout
Demello sold another 200 million euros ($226 million) in call options on German 10-year bonds on Tuesday, five days after a report showed the U.S. economy accelerated to a 2.4 percent annual pace in the second quarter, from 1.4 percent. Since then, a report showed U.S. service industries staged the broadest expansion in six years and orders flowed at a record rate. ``I wouldn't accuse Greenspan of mismanagement,'' said Milton Ezrati, senior economic strategist at Lord Abbett & Co., with $46 billion in assets. ``He misread the market's reaction.'' U.S. 10-year Treasury yields surged almost 90 basis points in July on signs the economic recovery is gaining strength, the biggest monthly increase since 1984. The rate on the German 10- year bond has gained 39 basis points in the same period. The yield on Japan's 10-year government bond more than tripled in July, after hitting a record 0.43 percent on June 11.
European Optimism
In Europe, the lowest borrowing costs since 1946, coupled with the prospect of tax cuts in countries including Germany and France, have bolstered optimism among executives and consumers. Business confidence in Germany, Europe's largest economy, rose to a one-year high in July and consumer confidence gained for a fifth month. Europe's services industry, which accounts for more than half of the economy, expanded for the first time this year. ``The European Central Bank will wait for some more data first to assess the impact from the latest rate cut,'' said Heinz- Joachim Neubuerger, chief financial officer of Munich-based Siemens AG, Germany's largest engineering company, in an interview. ``I don't think they will change rates again this year.'' The ECB said on Thursday it sees ``increasing reason'' to expect a recovery in the second half. Japan's economy probably grew 0.2 percent in the second quarter, after expanding 0.1 percent in the first, a Bloomberg survey of 24 economists showed. Japan reports gross domestic product figures tomorrow.
Next Move Up
Rate cut expectations have also been reversed in the U.K. after the Bank of England cut its benchmark lending rate to a 48- year low of 3.5 percent on July 10. Consumers are taking advantage of low credit costs to borrow at record rates. New car sales reached a record in July and service industries expanded at the fastest pace in 14 months. ``The next move by any major central bank will be an increase,'' said Marc Touati, chief economist at Natexis Banques Populaires in Paris. He expects the Fed to raise rates in October and December and the Bank of England and the ECB to follow in the first half of next year.
Some executives and economists say hopes for a quick rebound in the U.S. and Europe may be too optimistic, as long as the economies fail to create jobs. The U.S. unexpectedly lost 44,000 jobs in July, a sixth straight decline. And while shoppers kept spending in the second quarter, the main boost to growth came from the biggest increase in defense spending since 1951. ``We have yet to see the return of spending from businesses, including our own,'' said Henry Silverman, chief executive officer of Cendant Corp., the largest U.S. travel and real estate services company, in an interview last week.
Growth Without Jobs
Most European companies boosted profit by cutting costs in the second quarter, rather than by benefiting from increased sales. Siemens said last month it will cut another 2,300 jobs at its mobile-phone business to boost profitability. German unemployment rose for the first time in three months in July. Other companies are more optimistic about the prospects of a recovery. Bayerische Motoren Werke AG Chief Executive Helmut Panke said Thursday the world's second-largest maker of luxury cars sees ``signs of a pickup worldwide'' in the economy. Europe's Dow Jones Stoxx 50 Index has risen about a quarter from a six-year low in March and the Dow Jones Industrial Average is up about 20 percent since then. Japan's Nikkei 225 stock average has gained a fifth from a two-decade low on April 28.
Zero Rate Policy
Even in Japan, which has been hurt by falling prices for more than five years, signs of a pickup are mounting. Household spending -- 55 percent of the economy -- had its biggest gain in almost two decades in June as the jobless rate dropped for the first time in four months. That probably won't be enough to allow the central bank to end the zero rate policy, though. Bank of Japan Governor Toshihiko Fukui and Finance Minister Masajuro Shiokawa said the recent surge in bond yields shows a ``correction'' of investors' pessimism and they don't expect yields to rise further.
``Japan may not be able to achieve stable growth until 2010, and the central bank may not be able to scrap the zero rate policy before then,'' said Kazuhiko Sano, chief strategist at Nikko Citigroup Ltd. Nine of 12 economists surveyed by Bloomberg News said the bank will keep rates near zero for at least three more years. //www.bloomberg.com