Bond Outlook by bridport & cie, January 23 2013

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The outcome of the Japanese experiment is only one question unanswerable except with the passage of time. This week we have three more to consider.

Pertinent questions to which only time will provide answers:

 

1. Will the Japanese experiment in seeking inflation succeed?

 

2. Why, faced with a strengthening EUR, are bond investors moving from euro to dollar denominated bonds?

 

3. Why are Spanish government issues selling well at 5% when last year no one wanted them at nearly 8%?

 

4. Why are financial markets so sanguine about the US economy when social and income taxes have increased, but little progress has been made on spending controls?

 

We may not be able to answer these questions, but we can at least discuss them:

 

1. The Japanese experiment

 

After an initial fall in the JPY, the currency apparently stabilised at about 12% less than before the Abe move. However, yields on government bonds (JGBs) have fallen even further. Commercial banks are selling JGBs and buying foreign bonds as they expect higher interest rates once inflation increases and prices consequently decline. The only buyer of JGBs is the Bank of Japan, so it is really hard to understand why JGB prices have increased. We fear that we have only deepened the mystery of this unanswerable question!

 

2. The interest in USD-based bonds

 

A possible explanation is that the buying interest for USD bonds dates back several months, while the renewed confidence in the EUR as a currency has not yet impacted on bond purchases. Many lower-credit bonds have been, and still are, being issued in USD and are proving popular. However, as we pointed out last week, the premium as they move on to the secondary market has evaporated. Will the interest switch back to EUR-denominated bonds?

 

3. Spanish Bonds

 

The decisive factor here is probably less real progress in the Spanish economy than the “Draghi effect“. Nevertheless, Spanish labour costs have attracted inward investment (automotive). Answers to this question lie more in the federalisation project of the euro zone than in Spain itself.

 

4. Sanguine on US economy

 

The stabilisation of the housing sector is encouraging, as it alleviates the immediate cause of the crisis which began in 2007. The modest increase in taxation revenues makes a tiny step towards a reduction in the domestic deficit. Yet the fundamental problem remains of government and national spending far in excess of revenues. Just how the deficits can be narrowed without more economic pain is beyond us!

These four unanswerable questions hide a general one about all financial investments: how can lenders achieve a fair return compared to the cost of borrowing? The market’s answer is to turn to “risk assets”. That implies putting a price on them beyond fundamentals – the perfect environment for a bubble. So we are left with another question: is this a bubble environment for many financial assets, and, if so, when and how will it burst? We thank Andrew Hunt for the pun about going down the “Abe Road” – in the Beatles’ song “Abbey Road”, to go there was to visit the pawn shop!

 


Macro Focus

 

 

United States

 

The rebound in homebuilding accelerated 12.1% in December to a 954,000 annual rate, the best year for the industry since 2008.

 

Overall, US manufacturing advanced 0.8% in December, but manufacturing in the Philadelphia region contracted in January. In addition, confidence among American households fell to a one-year low, as higher payroll taxes took hold. The confidence index dropped to 71.3, the lowest since December 2011.

 

The cost of living was little changed in December. Costs rose 1.7% in 2012, compared with a 3% increase in 2011.

 

Eurozone

 

Construction output fell in November as declines in France (-0.5%) and Italy (-3.4%) offset gains in Germany (+1.0%) and Spain (+1.2%). Construction in the 17-nation euro area decreased 0.4% from October and 4.7% from a year earlier.

 

December consumer prices remained unchanged at 2.2% compared with a year ago.

 

The ZEW index climbed to 31.5 from 6.9 in December, the highest since May 2010.

 

United Kingdom

 

Retail sales including fuel fell in December by 0.1% from November, with household goods falling the most in almost three years. However, compared with a year earlier, total sales rose 0.3%.

 

Asking prices for property London rose 3.6% from the previous month and 9.7% from a year earlier to an average of £ 480,890.

 

Britain’s budget deficit widened in December as government spending jumped and a struggling economic recovery weighed on company profits. The shortfall excluding government support for banks was £ 15.4 billion compared with £ 14.8 billion a year earlier. Spending rose 5.4% and revenue climbed 3.6%.

 

Switzerland

 

Producer and import prices advanced for a fourth month in December, led by higher domestic costs. Prices of products increased 1% from a year earlier. Import costs were unchanged in the month and increased 0.1% from a year earlier.

 

Industrial production slowed down in Q3, resulting in a growth of 2.2% from a year earlier, while retail sales YoY rose 2.9% in November.


Dr. Roy Damary