Bond Outlook February 7th

Over the last weeks, optimism about the US economy has reigned, not least in this Weekly comment. Lower oil prices (compared with last year, and notwithstanding the recent rally) have allowed consumer spending to continue unabated in the USA. The beginning of a shift in relative return back to labour from capital has raised hope that households will feel little or no squeeze as the housing market slows. A fortnight ago we observed that the question about the US economy’s landing being soft or hard was misplaced; there was going to be no landing at all!

Yet there has to be a landing sometime. The unsustainable — in this case a country and the households in it living beyond their means — has eventually to be brought to account. To continue the aircraft metaphor: the plane was gently approaching the runway when the pilot pulled back the joystick, opened wide the throttle and flew off again. Now the co-pilot, in the person of Ben Bernanke, has to wrestle with the pilot to circle round again and really land, before the fuel runs out, and preferably softly.

But who is the pilot? Is it the US administration, resolutely set against accepting facts, be they economic or geopolitical? Is it the Chinese Government determined to keep selling goods to the USA even if that means so much vendor credit? Is it the leveraged hedge funds combined with credit derivatives supplying money independently and beyond the control of central banks? Is it the carry trade borrowing massively in JPY and CHF, thus providing even more liquidity? Is it emerging markets using their surpluses to buy back their foreign-denominated bonds in favour of local currencies? The answer must be that it is no single one of these, but all of them. Bernanke has a lot to wrestle with! What compounds his problem is that he needs to oppose these forces, but not so severely that they all reverse at once, leading to the hardest of landings.

While we and many other commentators are alert to the risk of reversal of the current benign but fundamentally unstable economic situation, financial markets seem perfectly content to assume indefinite continuation of the status quo. The particular impact of this on fixed-income markets is:

• to accept spreads on lower credit bonds which seem inadequate for the risk
• to diversify currency holdings to seek better yields (we can scarcely complain – that was our recommendation!)
• to incorporate or expand the equity component in bond portfolios via convertible bonds
• to buy more exotic fixed-income products, such as CMS (still more issues have become available even since last week) and reverse convertibles

The attraction of the CMS issues relies on the supposed steepening of the EUR yield curve, while reverse convertibles depend on continued good stock market performance, both of which are questionable and which bring us back to the issue of the sustainability of the current economic situation.

As the ECB continues to raise rates (with 3.75% expected for March, and a further 25 basis points after that), and the Fed keeps making noises about a rate rise coming after some months at 5.25%, the risk of inflation has to be taken seriously by investors (as well as central banks!). Some of our clients are therefore increasing the inflation-linked portion of their portfolios.

Focus

(?) BRL : the Brazilian currency has suddenly broken out of its range of 2.13 – 2.16 to the USD to reach 2.10 thanks to the country’s positive fundamentals and despite massive purchases of the USD by its Central Bank

(+) The Turkish lira (TRY) has moved back up to the level of mid-May 2006. This is a nice correction given that it had fallen to 1.70  to the USD, but is now back to below 1.40. Obviously lifting the bank rate from 13.25 % to 17.50 % is largely responsible.

(+) Note the good performance of some callable corporate bonds (despite our reservations about this class), notably EUR issues such as BAYER 2105 (sic) and TUI AG, or in USD like the PORSCHE perpetual,  which, despite a rather low rating, offer a generous coupon and structure that investors seem to appreciate.

(+) positive for bonds (-) negative for bonds (!) watch out (?) begs a question

Recommended average maturity for bonds.

No change.