Bond Outlook by bridport & cie, December 15th 2010

Our view of the European austerity programmes has basically been that they are a necessary consequence of over-indebtedness and irresponsible spending and lending. We would argue the same for the USA, and can but regret that the political mood in that country continues to deny the need for any deviation from the path of deficit spending. In Europe, however, a backlash is developing. It is more fundamental than British students rioting against increased tuition fees or the French protesting against having to work longer but still less than everyone else. The malaise is best expressed as “the people versus banks”. As matters currently stand it looks like the taxpayer has to bear all the costs while banks are being saved from their own follies.

What might be the economic consequences if this backlash deters European policy makers from a 100% bail-out? In a sense it already has, in that Merkel is opposing contributing more to a central bail-out fund and vetoing any central agency issuing its own bonds. Our expectation is that the central fund will eventually be allowed to expand, but that restructuring bank and sovereign debt is inevitable, with haircuts for bond holders. It is hard to imagine that the leaders will be clever enough to navigate the path, but their objective will be to save the euro while allowing restructuring with modest haircuts, thereby transferring some, but not all, of the burden from taxpayers to banks and their creditors.

All this says that European government debt is unattractive as 2011 arrives. That view is reinforced by our long-held expectation that yield curve will steepen further – this is finally happening (somewhat after we thought). Some believe that the increase in long-term interest rates reflects optimism about economic recovery in the USA. In contrast, we believe the cause to be ever-greater US Government borrowing, a well-founded fear of inflation and the consequence of quantitative easing. The steepening of the USD yield curve is mirrored almost everywhere, mainly out of sympathy with the USD, but also because markets are placing less trust in governments. Moreover, the growing distrust is extending to the entire monetary system.

There is a certain parallel between the Fed’s QE2 – put in place in the absence of government action – and the ECB doubling its reserves to increase its bail-out capacity in the light of the inability of EMU leaders to develop a common policy. We wonder whether we will eventually see European politicians protesting that the central bank is usurping their role. That is certainly the case in the United States. Bernanke’s QE2 is now strongly opposed by Republicans, while the Administration seems to have no policy of its own. “Fed-haters” (an incredible term, but which is catching on) point out that T-Bond purchases by the Fed of 7-10 year maturities were meant to lower interest rates, but appear to have achieved exactly the opposite.

A Fed with a remit restricted to inflation control and with no responsibility for the economy as a whole is one ingredient in a gradual revamping of the global monetary system. Another ingredient is China’s use of its own currency for international trade in Asia and, for Brazil and Russia, the Real and the Rouble respectively. What a bizarre world that its strongest currency is that of a small country in the middle of Europe with a population of only 7 million and very few natural resources: the CHF has now strengthened to less than 1.30 to the EUR and is 3% heavier than the USD.

In addition to wondering whether CHF-based investors should even bother about a few extra basis points in other currencies, fixed-income investors cannot ignore the forthcoming interest-rate risk for many bonds as yield curves continue to steepen. Of course, there comes a point when higher long-term yields become attractive. In the meantime, however, sovereign bonds (pure trading opportunities in peripheral countries apart) offer poor overall returns. Quality corporates should however be at least partially protected by continued narrowing of spreads as the risk of default declines with gently improving economies.

Focus

• US: the Senate supported Obama’s USD 858 billion agreement with Republicans to extend Bush-era income-tax cuts. Retail sales for November sales rose 0.8%, and October sales results were revised significantly higher. Consumer sentiment rose to 74.2 from 71.6 at the end of November, a 6 month high. November PPI showed a significant headline increase (0.8% vs. 0.4% previously)
• UK: the inflation rate accelerated to a six-month high of 3.3% p.a. in November, boosted by food and clothes prices
• Europe: France backed Germany in refusing to add to the European Union’s EUR 440 billion rescue fund and rejecting joint euro-area bonds. The outlook for the Spanish banking system remains negative because profitability will be “severely tested” (Moody’s)
• Germany: industrial production rose almost three times as much as forecast in October, led by demand for investment goods. Production jumped 2.9 % from September
• Ireland: the government introduced a law allowing it to force junior bank bondholders to share losses if needed to protect financial stability. Ireland’s credit rating was cut three levels by Fitch from A+ to BBB+
• Denmark: record foreign demand at Denmark’s EUR 75 billion mortgage-bond auction sent yields to all-time lows

Recommended average maturity for bonds (corporate/government)

Government bonds are losing attraction. Shorten. Maintain barbell* in corporate bonds in EUR and USD (cash/7years).