Bond Outlook February 22nd

This week, we shall consider the reaction of different groups of market participants to the current shape of the yield curve and the expectations for both the USD and EUR curves.

The flat US yield curve, with full inversion expected as the Fed goes up from 4½% to 4¾% in March, and very likely 5% or higher thereafter, presents investors with a dilemma, but of a different nature for private investors, institutional investors and central banks. Private investors have little incentive to buy long maturities when they can achieve the same yield with T-Bills without taking the risk of the long end of the yield curve rising. Indeed, data reported by La Chronique Agora show both a decline in overall private foreign purchases of US assets (from USD 50.8 billion in November to USD 12.7 billion in December) and also a distinct preference for short maturities. Nevertheless, the US Treasury was still able to issue its new 30-year bond without difficulty. That is where other categories of investor come to the rescue. One is made up of pension funds: there is a genuine shortage of very long-term T-Bonds for pension funds, which must seek to match long-term assets and obligations irrespective of likely price changes over the life of the bonds. The other consists of the central banks: the continued policy of Asian governments, via their central banks, to use T-Bond purchases as a tool to support the USD.

On the other side of the fence (borrowers) corporate bond issuance has increased at the expense of new equity. This is partly to fund M&A activity, but also suggests that corporate treasurers are taking advantage of cheap money while it lasts (and that cannot be very long).

In Euroland, the yield curve is flattening but is still well behind the USD curve. Yet European corporations are also seizing the opportunity of locking in still relatively low long-term financing costs, even to the point of buying back short-term bonds and refinancing them long-term (the example of Volkswagen). However, the EUR is less vulnerable to the disenchantment of foreign investors than the USD. Consequently, a rise in long-term rates is not so close and our recommendation of bar-belling for EUR and CHF remains valid.

It is rather obvious that the USD/EUR exchange rate is being driven by short-term interest expectations. Bernanke says he will not stop at 4¾%, and the dollar strengthens; Trichet says that the EUR repo rate will rise, and it is the euro’s turn to strengthen. Our view is that the long-term outlook is in favour of the EUR, perhaps even too much in terms of international competitiveness.

The willingness and ability of American consumers to spend more than they earn never ceases to amaze us. January’s consumption statistics made it look like the belt had been thrown away, never mind tightened! Yet borrowing is slowing, as witnessed by the decline in the growth of consumer credit from all sources from a peak in August 2005 of 12% growth to 9% in January (approximate but indicative figures). Of course that is still growth; the real question is when will borrowing cease growing altogether as households return to saving.

Last week we mentioned the interest of fixed-income investors in the less-common currencies, but where bonds can still be settled internationally. As it happens, many of those currencies have lost value this week, reminding us of the permanent relationship of risk and reward. For example, we have written three warnings since October 2005 on overvaluation of the ISK, which has dropped 9% this week. Readers will shortly receive today our latest thoughts on this. Nonetheless, a long-term shift in favour of such diversification of bond portfolios remains underway.

Brazil is the “star” among the emerging countries issuing bonds in local currencies. It has just eliminated its tax on capital gains on bond trading for investors resident in countries other than tax havens. This is likely to reinforce the gradually replacement of USD/EUR denominated debt in favour of BRL denominated.

Recommended average maturity for bonds in each currency

Stay with bar-belling for CHF and EUR.