Bond Outlook February 10 2010

Whilst merely murmuring last week, bond markets have begun to speak much more forcibly, and are now perhaps even shouting! Spreads are widening and, even more significantly, market makers are loath to bid, even for retail order sizes. Our recommendation in favour of high quality and short maturities has become the main preference of fixed-income investors, and this has led to a severe reduction in liquidity. Ominously the drying up of liquidity in bond markets has, in the past, been a precursor of a financial market crisis – not quite the same as an economic crisis, but closely linked.

The immediate cause of the present decline of liquidity and of EUR weakness is, of course, the Greek debacle, although the forthcoming cessation of quantitative easing may also be playing a role. There is a strong argument in favour of casting Greece adrift on the grounds that at both government, and populist levels, cheating is such a way of life that a bail-out would be undeserved and would create a new moral hazard. There is a counter-argument however that says that if banks have been bailed out, a country is at least as worthy a cause.