Bond Outlook by bridport & cie, March 16 2011

Despite their terrible suffering, the Japanese people have historically proven themselves able to recover and rebuild after disasters, and indeed to go on to reach renewed heights of economic prosperity. Thus it was after the WW2 and the Kobe earthquake, and thus it will be after the latest tragedy.

For years, the West has been asking Japan to consume more of both their own, and imported, goods. That request is about to be met in an unexpected way, but Instead of rice and whisky (two areas protected against imports) there will be a surge in the consumption of construction materials and equipment. Reconstruction will be much less costly than the global financial crisis, but, more importantly, it will be qualitatively different. The financial crisis wiped out paper wealth – real enough to those who lost it, but involving very little depletion of physical assets. The Japanese destruction is of physical assets, and they have to be replaced.

The Japanese private sector will have to dispose of foreign assets and repatriate the yen, but these funds will be recycled into purchases of foreign goods and equipment. The short-term effect will be to strengthen the JPY and weaken stock markets, but a new equilibrium will emerge with the global economy being given a boost.

Not surprisingly, the immediate response of financial markets was a flight to quality: stocks down, CHF up and government bond yields down. Yet this move already looks to be nearing its end, and the more positive, longer term economic consequences of the tragedy are beginning to assert themselves.

While the Fed is claiming ever more strongly that QE will end in June, we remain sceptical. Despite our relatively sanguine interpretation of the Japanese tragedy, there will be at least one negative impact on the US economy in the form of interest rate pressure. The US Treasury has enormous borrowing needs; (US fund manager, Axel Merk, calculates that refinancing needs for foreign-owned T-Bonds are running at USD 5.4 billion per working day, and that is before any expansion in borrowing requirements). Japan, until now so willing, along with China, to buy Treasuries, will be a net seller. Where will the Treasury go when it cannot raise funds at a bearable cost on the open market? To the Fed, of course!

We draw a distinction between higher interest rates in the sense of yield-curve steepening, and higher short-term rates. The Fed, as well as the BOE, are very fearful of raising the latter, all the more so post-Japan. Maybe the ECB will hesitate a little, but this appears less likely. There is a growing confidence in the euro zone that the peripherals’ debt can be contained, and the cost of bail-outs to Ireland and Greece might even moderate somewhat. As we have long suspected, the German Government is facing up to domestic grumbling to do what it has to do: use its economic strength to bolster the euro zone.

Japan has taken investors eyes off Libya and Bahrain. Both are unfolding human tragedies; the greater the viciousness of Gaddafi, the more other despots will spurn world reprobation to crush rebellion by military means, i.e. killing their own civilians. Bahrain has an additional dimension in reflecting a Shia versus Sunni struggle in which Iran is most likely involved. We cannot tell where that struggle will lead, but it is likely to have worrying implications for petroleum prices and the global economy !

Market Focus

• Japan: the tragic events and unfolding news of a potential nuclear disaster led to a sharp flight to quality. The VIX index moved to the highest level in 6 months as equity markets fell and high grade government bond markets rallied with yields falling sharply. Spreads on High Yield and Emerging market sovereign bonds moved significantly higher on the week

• Fed: the FOMC statement released last night was taken positively by markets as the Fed noted that overall conditions in the labour markets and the economy appear to be gradually improving. The Fed acknowledged upward pressure on inflation from input costs, but remains sanguine on longer-term inflation

• USA: a bond market measure of inflation expectations (5 Year forward breakeven) declined from 3.28% to 2.97% in agreement with Bernanke that record oil and food prices will be transitory. Consumer confidence fell in March to the lowest level in 5 months, although February retail sales rose by the most in 4 months. Unemployment declined in 24 states in January. Foreclosure filings fell to the lowest level in 3 years. The trade deficit fell by 15% in January

• Europe: EU officials broadened the scope of the €440 bln bail-out fund and eased the terms of loans to Greece. However they declined to authorise the fund to purchase bonds in the open market or finance debt buy backs by governments. German exports declined in January by the most in 10 months, after industrial production increased 1.80% from December

• Spain: Moody’s cut Spain’s credit rating to Aa2 to reflect the cost of shoring up the banking system. Inflation accelerated by the most in 2 years, whilst core consumer prices rose 1.80% from a year earlier. 97% of homeowners in Spain have variable rate mortgages, making the economy more vulnerable to a rising interest rate environment

• Portugal: despite the announcement of additional budget cutting measures, yields on Portuguese 5-year bonds reached a record level as markets speculated that the government may be close to requesting financial aid

• UK: Fitch re-affirmed the UK’s AAA rating based on the government’s efforts to reduce the deficit and easing risks related to the banking sector. The BoE remained on hold. Manufacturing production jumped by 1%, the most in 10 months, in January. The trade deficit declined to GBP 7.06 bln from a record GBP 9.69 bln in December

• Switzerland: the KOF institute suggests that the economy will grow by 2% in 2011, stronger than the previous forecast of 1.70%. Inflation reached 0.50% in February after 0.30% in January

Disclaimer
This document is based on sources believed to be reliable, accurate and complete. Any information in this document is purely indicative. This document is not a contractual document and/or any form of recommendation. Expressions of opinion herein are subject to change without notice. We strongly advise prospective investors to consider the suitability of the financial instruments, based on the risks inherent to the product and based on their own judgment. It is not intended for publication. This document may not be passed on or disclosed to any other third party without the prior consent of bridport & cie s.a. © bridport & cie s.a.

March 16, 2011

Dr. Roy Damary