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Bond Outlook May 12 2010

Three emergency operations in a row – US subprime, euro debt and UK deficit – apparently controlled for the immediate future. But the longer term still demands action. Some action is appearing.

Bond Outlook [by bridport & cie, May 12th 2010]

The current modus operandi in “Western” economies is one of fighting fire after fire. Initially, it was the sub-prime crisis in the USA, then the euro crisis, and, more recently, the UK debt crisis. The fires appear, for now, to have been extinguished, however the resources devoted to dousing them have been both enormous, and, in most cases, belated. A few more days of volatility may be expected before we see the end of recent exchange rate volatility. Ultimately we expect a lower EUR, a stronger CHF and stabilisation in the GBP after its recent falls.


In none of these three crises is there an assured long-term solution, so this week we think it will be helpful for our readers to consider the medium-term outlook.


The euro zone must grapple with the differences in fiscal policies amongst it members. Two elements are now appearing in this regard:


  • The ECB is more closely following the example of the Fed and the BoE in becoming an active buyer (and in due course, seller) of government and agency bonds
  • The deficit countries are beginning to cede a degree of sovereignty. They are basically ‘knuckling under’ by instigating austerity programmes designed to reduce fiscal imbalances. Ireland set the pace in taking voluntary action, Greece followed on a much less voluntary basis. Now Spain is acting of its own volition, and even Italy is making noises in the right direction


The euro crisis has clearly acted as a wake-up call. While financial markets remain sceptical (and many participants, such as the large American Investment Banks, appear to be prospering from the resulting volatility), the authorities are determined to ensure the long-term success of the single currency. At the present time, there is no such security as a “euro-zone” bond, yet such a bond, or more correctly, its issuing authority, would be a natural partner to the single central bank. The fact that the EU has members who are not in the “euro zone” is a complication, but such a move to greater centralisation of the fiscal function for countries using the same currency must be on the horizon.


A possible issuing authority would be the European Commission, with as an alternative, the putative ‘European Monetary Fund’, which has been created in all but name by the euro zone members as part of the new bail-out package.


The UK has the great advantage of having its own currency and a single Treasury. The new Government has certainly declared its commitment to deficit reduction, and we expect it to follow through.


It is in the USA where, as we have written before, the authorities are just not “getting it”. They rejoice when household consumption increases ahead of earnings (as it is now doing) and appear to equate economic recovery with an expansion of consumption. It seems to us that many are misinterpreting inward flows to dollar assets as validation of this economic ‘success’ when it is in fact the customary actions of foreigners increasing their purchases of both US securities, and the USD, in a time of international stress. We appear to be witnessing the same old routine: the increasing trade and current account deficit is perceived as of no import as foreigners are so willing to fund it. No sooner however do we see the terms of trade move a little in the USA’s favour because of the weaker dollar, than the trade deficit increases because of increased spending. It is also worth noting that the exchange rate advantage of the USD is being lost as the EUR weakens.


In the euro zone, individual countries behave irresponsibly, while in the USA, it is individual states that do so. A big difference, however, is that, overall, the euro zone does not have a current account deficit, and does not depend on Asian buyers of government bonds. For the moment the USA is the clear beneficiary of flight to safety flows, and the credibility of the euro zone is low. For just how long this situation continues remains to be seen.


Presumably despite, rather than because of, Trichet, the ECB is expanding its bond-purchase programme, while the Fed is doing the opposite in beginning to sell its mortgage-backed securities. This reflects the relative stages of ‘recovery’ of both economic areas. If we return to our fire-dousing simile, the fire is out, and now the excess water has to be cleaned up. In this task, the USA has the advantage that the fiscal and currency authorities do at least act in partnership. Oh for such a partnership in the euro zone!




(+) USA: total employment has improved by a further 290,000 in April, although the unemployment rate remains at 9.9%. New claims are at 440,000


(–) UK: producer prices are up 5.7% year on year but the BoE is keeping the bank rate at 0.5%


(!) Europe: with Q1 unemployment in the EU still at 9.6%, the ECB is maintaining its repo rate at 1%


(+) Russia: inflation declined in April to 0.3% over March, and to 3.5% over the first four months of the year


(?) Norway: the bank rate was raised 25 bps to 2%


(!) Greece: industrial production declined 3.7% in March after the 9.2% drop in February


(+) Spain: after 18 months of economic contraction, Q1 saw an exit from recession with modest GDP growth (0.1% over Q4)


(+) Switzerland: inflation stabilised at 1.4% per annum in April


(?) Argentina: an attempt is underway to deal with unsettled debt from the 2005 restructuring


 (+) positive for bonds (–) negative for bonds (!) watch out (?) begs the question


Recommended average maturity for bonds (corporate/government)


Current market conditions suggest a different maturity recommendation for corporates and government bonds.

07.04.2010 2013 2014 2013 2016 2015 2017 2017 2017

Dr. Roy Damary

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