London, England

With the exception of Norway, which recently signaled the likelihood of higher interest rates this fall, the rest of Europe is mired in a severe slump that will keep short-term interest rates low for the foreseeable future. Long-term bonds, however, are another story altogether and should be shorted as pressure continues to mount on bloated government balance sheets thereby forcing longer rates higher.

Heading into Monday’s trading the entire gamut of short-term government bond markets are entering the week on a strong note. The United States and Europe saw bond yields fall sharply last week – triggered by poor U.S. consumer and retail sales data.

Germany and France, which surprised the markets with positive Q2 GDP growth last week, nevertheless saw short-term bonds outpace long-term bonds. If economic growth is seemingly making a comeback after falling off a cliff from the September to March period then bond yields throughout the curve should be rising, not declining. The fact that rates are declining recently shows that global consumption remains weak and the prospects for a sustained economic rebound are tentative at best.

Government bonds with maturities under three years continue to look attractive and should be purchased instead of staid and low-yielding cash rates. This applies to U.S. and European money-market rates now at 0.43% and 0.83%, respectively, for three-month rates.

The only exceptions to this strategy are British and Norwegian government bonds, which I don’t like for different reasons. In Britain, the pound is likely to start softening again after a huge rally from its oversold levels while in Norway the central bank appears poised to hike rates before the end of the year. I do, however, continue to like the Norwegian krone.

Over the last few months investors have started to price in an interest rate hike by the Federal Reserve. Twice since May Treasury and Euro-zone bonds have declined sharply on this false premise; this won’t happen until 2011 at the earliest. Investors should accumulate short-term government bonds amid temporary market declines because a long-term growth recovery is not in the cards.

High quality short-term government debt might also be at the cusp of another big rally this fall as stocks finally come back down to Earth following a massive 50% rally since March. Over the last eleven years the correlation between declining stock prices and rising bond values has growth extremely acute amid market dislocations. Benchmark ten-year U.S. Treasury bonds yielding 3.75% or higher look appealing; the same is true for German 10-year bunds yielding north of 3.50% and should be purchased on any short-term correction this summer.