Bond Outlook October 24th

Just as last week we had to present both sides of the inflation vs. deflation argument, and can only wait for a definitive answer, so this week the sense of “wait and see” continues. Our tentative answers to several key questions are in italics:

• Will the Fed cut rates next week? If it does, is the implied USD weakness priced in or will the USD fall still further? Yes, but we still believe the bottom is not yet in sight.
• Will the combined weight of a drop in housing wealth and poor income growth finally slow US household spending? Yes, but the spend-spend mentality is remarkably resistant, so the impact may not be immediate!
• Have all the CDO losses and the losers been identified? We fear not. AIG may have spoken up, but many insurers (for example) are saying little.
• Will the rest of the world cope with a US slowdown? If a mere slowdown as we suspect, yes, but if a real recession, everyone will suffer.
• Has the banking liquidity problem been solved? To judge from our experience in bond execution, things are slowly getting back to normal, however, bank risk appetite will be lower than prior to the credit crunch, which will have an affect on growth.
• Will the USD 75 billion + fund set up by major banks to solve problems with mortgage-backed securities succeed? Enthusiasm is declining. In the end the fund is too small and designed not to buy CDOs and thereby set a price, but rather to lend against CDOs as collateral.
• Will the USD 16 billion fund set up by Countrywide be enough to bail out insolvent sub-prime borrowers? By itself, no — not with USD 250 billion sub-prime mortgages due for reset in 2008 and other ARMs being reset thereafter, but if other lenders join the bail-out, maybe.

On the last point, mortgage lenders have seen the writing on the wall, or at least noticed the Bill introduced by the Democrats to allow borrowers to sue lenders for predatory mortgage selling. Selling mortgages to the obviously insolvent and laying off the risk is a moral hazard too far!

The sense of hesitation in the face of the above questions is being felt in the bond markets. Many fixed income investors are simply “parking” their money in T-Bills, even foregoing the spread from Libor, at least while waiting for the Fed decision. Clearly the bond market is not at ease, as witnessed by a shift (“flight” is too strong a word) to quality over the last few days.

The “Caterpillar” event of last week (and subsequent drop of 367 of the DJIA) contained the hope that non-US construction activity would offset the fall in US housing activity. Decoupling, or “rebalancing” as we usually call it, is not just possible, but is underway. Even so, in Hong Kong (where this Weekly is being written during the AsiaHedge Conference), hedging against a precipitous drop in share prices is a theme tempering the generally bullish outlook of the speakers about Asian investment opportunities.

Stephen Roach (as ever even more bearish than we) has again “spoken” with emphasis on the US consumer running out of steam, the dollar continuing to fall and “skittish” foreign investors being disenchanted with diminishing US assets. He calls for central banks to drop their obsession with consumer prices and to take asset inflation seriously. His view on the USD is almost universal, but begs the question, “Where to put one’s money?” The EUR is the obvious answer. If only the RMB were convertible!

Focus

(+) USA: after publication of the Beige Book last week, with its emphasis on the slowdown in growth since August and uncertainty about the future of many industries, the bond market took off. The 10-year yield had already fallen through 4.6% and went down early this week to below 4.4%.

(+) Fed: the proportion of analysts expecting a cut in the target rate has increased over the past week from 32% to 64%; 2:1 in favor of 25bps vs 50 bps.

(+) Quality: the preference for risk-avoidance has been clear this week, with government bond yields dropping faster than corporate bond markets.

(!) Japan: the measure of business confidence, the “Tankan”, is at its lowest for two years.

(?) Sovereign Wealth Funds: the G7 are concerned about Asian and petroleum producers SWFs seeking better returns away from the USD, thereby hastening the dollar’s fall.

(+)Turkey: the PKK’s proposal for a cease-fire has helped the TKL to recover some of its 4% loss since the border fighting

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

Recommended average maturity for bonds.

Generally medium dated, as long term yields seem unlikely to rise, at least not yet, and short-term rates will be lowered.

Currency:

USD

GBP

EUR

CHF

As of 22.08.07

2014

2010

2014

2011

As of 25.07.07

2014

2010

Floaters

2011

Dr. Roy Damary