Bond Outlook by bridport & cie, September 12 2012

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Draghi has acted where politicians hold back, giving Europe the break so needed to continue its move to a federal structure for the euro zone.

Even his detractors admit that Draghi has pulled off a master coup. The markets certainly think so; apart from the obvious strengthening of the euro, a lowering of spreads for the periphery country bonds and a rise in stock markets, new corporate bond issues have been rushed to the market. The German Constitution Court was never going to fully oppose the ECB. Fixed-income investors are flocking to corporate issues from Europe’s south, accepting yields scarcely half of what was available barely month ago.

 

Long may it last, and may the opportunity given by “politician” Draghi to the official politicians of Europe not lead to any slowdown in reforms and the march to a federal structure for the euro zone. We would add that the democratic deficit which we described last week (and which has also been discussed in the FT this week) must also be repaired. What is economically necessary for a single currency may not be politically digestible: a Europe run by central bankers!

 

Do not be too shocked by the idea. Ask yourself who is making economic policy in the USA. Who is deciding whether the zero-interest rate policy will continue far into the future and whether QE3 should be introduced? The answer is the same, a well-known central banker.

 

Nevertheless, the democratically elected leaders cannot renege totally on their responsibilities. A particular issue facing them now is the extent to which federalisation, essential to maintain the euro, should cover the countries of the EU outside the euro zone. This issue will come to the fore as the banking union is put into place. It is almost impossible to imagine a British Government allowing UK banks to be supervised from Frankfurt, even if the BoE is a major shareholder of the ECB.

 

One entity breathing a great sigh of relief over the euro and hoping that the recovery lasts is the Swiss National Bank. About three quarters of the SNB’s CHF 400 billion plus reserves are now in euros. There is a remarkable parallel between China’s relationship to the USD and Switzerland’s relationship to the EUR. The reserves of both countries are so dominated by another’s currency that they can ill afford to let that other currency decline in value.

 

We once feared that quantitative easing, or to give it its new name in the euro zone, “outright monetary operations”, would lead to inflation. Many believe it still will. Our fears have moderated however, because deflationary pressures are working in the other direction. We had put that down to weak western economies led by the USA’s need (recognised or not) to deleverage. Of more fundamental concern (and for this we acknowledge Harry Dent of “Boom and Bust”, reported by John Mauldin) is the tidal shift in the demographics of developed countries toward retirees and “empty nesters”, to the point that household spending is not being maintained. Thus “demand-pull” inflationary pressures are greatly attenuated. “Cost-push” pressures remain, but even they are weakening for exactly the same reason, an ageing Chinese population and a slowing economy.

 

As Pimco asked last month, is the developed world becoming “Japanified”?


Macro Focus

 

United States

 

The ISM Manufacturing index fell to from 49.8 in July 49.6, the third consecutive month of decline, the longest since the recession formally ended in 2009. However, the ISM Non-Manufacturing index climbed to a three-month high of 53.7.

 

While payrolls rose modestly, with 96,000 workers added, the unemployment rate fell as people left the labour force. The productivity of workers climbed at a 2.2% annual rate.

 

Euro Zone

 

Europe’s economy was pushed into a contraction of 0.2% in Q2 over Q1 as consumers cut spending and corporate investment fell. Finland and Italy contracted -1.1% and -0.8% 2001. Portugal’s economy shrank for a seventh quarter (-1.2%). In contrast, German industrial production unexpectedly rose 1.3% in July, French industrial production increased 0.2% and French business confidence climbed for the first time this year from 90 to 93.

 

United Kingdom

 

Industrial production rose 2.9% in July as manufacturing rebounded from the disruption caused by the extra public holiday for the Queen’s Jubilee. Retail prices rose 1.1% from a year earlier.

 

House prices fell to an average £ 160,256 (-1.1% YoY). Food-price inflation was unchanged at 3.1%, while non-food prices fell an annual 0.1%.

 

Switzerland

 

The jobless rate remained at 2.9% and the consumer prices fell 0.5% from a year ago, after decreasing 0.7% in July.

 

Swiss National Bank said Switzerland is concerned about an increasing risk of defaults in the mortgage market as well as about a “sizable correction” in property prices.

 

Japan

 

The government may run out of money by December as opposition parties block deficit-financing legislation. Japan slashed its estimate of second-quarter growth from 1.4% to 0.7%.