Bond Outlook by bridport & cie, December 8th 2010

What does a US President do when faced with an unsustainable budget deficit, a housing market slump, stubbornly high unemployment, a hostile Congress and growing popular disenchantment ? The answer, we have learned this week, is to climb down. Forget trying to bring the budget back into balance, maintaining a strong dollar or preventing further rises in long-term interest rates. Simply return to the old routine of cutting taxes, increasing entitlements and borrowing ever more, providing a sticking plaster to cure short-term ills, whilst the more serious, longer-term, budgetary imbalances continue to deteriorate.

You immediately receive a positive response from the stock market, politicians and commentators, with just a few curmudgeons pointing out that the short-term stimulus was at least supposed to be part of longer-term budget control? Where, we have to ask, is that control?

We have often referred to the difference in approach between the economic policies of Europe and the USA. We had thought, or rather hoped, that the US authorities might take a leaf from Europe’s handbook and be more serious about taking steps to correct the budget imbalance, with the inevitable belt tightening which these measures would impose. Our hopes dashed, we can only wonder how the USA can get away with what no other country or currency zone is able to.

Part of the answer lies in the privileges of owning the world’s main reserve currency (whilst ignoring the responsibilities that go with those privileges). Part lies in China’s ongoing support of the USD (yes, it wavers, but is still fairly solid, driven no doubt by its substantial holdings of US Government debt). The third reason however highlights a major difference between the USA and Europe: the market’s traditional faith in the USA is still strong enough for there to be only modest pressures on authorities to correct the country’s economic imbalances. That is very different from Europe, where markets remorselessly target any economic weakness and oblige the authorities to act, whether they really want to or not.

Putting it bluntly, the market attacks on Greece and Ireland, and the menace on other peripheral countries, have already forced action by political leaders. It looks like their short-term rescue efforts are bearing fruit – as we write, markets appear calmer than they have for some time. In stark contrast to the USA, these same market pressures will have the happy effect of ensuring that the long-term defects in the EMU will ultimately be repaired. The choice between a split in the euro zone, or greater political union, appears to be favouring the latter route.

The concept of market pressure pushing governments into action is not limited to the euro zone. In the UK for example, the austerity programme is clearly a reflection of the fear of market forces on the value of Sterling, and the future level of interest rates.

In the USA, the door has been firmly slammed on the pressures of market forces. They have not however gone away. They will continue, for example, to weaken the USD and steepen the yield curve. Inflation will eventually break out. We would have thought that wisdom would suggest that these developments be anticipated and countered. Too bad that wisdom appears to be in such short supply.

The bond market is more illiquid this December than in most years. We reiterate that there are more bargains on the buy side than the sell.

Focus

• USA: fewer jobs were added than forecast in November and the unemployment rate stayed at 9.8%. The tax cuts for high-incomes are extended, as is federal unemployment insurance. The payroll tax cut by $120 billion for one year
• UK: Manufacturing expanded twice as much as economists forecast in October. Output rose 0.6% from September, the most in seven months
• Ireland: first votes on the EUR 6bln budget were in favour of the new budget, which adds around EUR 14bln to austerity measures
• Euro Zone: immediate aid for Portugal and Spain or an increase in the EUR 750 billion crisis fund were ruled out. Preference is for ECB bond purchases to calm debt-spooked markets: EUR 1.965 billion of bond purchases, the most in 22 weeks. The ECB kept interest rates at a low, and delayed its withdrawal of emergency liquidity measures
• Europe: Moody's has taken rating actions on the debt and deposit ratings of eight Hungarian banks, following the downgrade of the Hungarian government's rating to Baa3 from Baa. Corporate bond sales dropped to their lowest in a decade last week: EUR 1.35 billion versus EUR 6 billion the previous week
• China: bonds rallied the most in almost two years last week as funds were pumped into the financial system, after banks were ordered twice last month to set aside more money as reserves
• Switzerland: consumers stepped up spending in Q3, helping counter a drop in exports and letting GDP rise 0.7% from Q2. Inflation held steady in November at 0.2% over twelve months as a stronger franc reduced the cost of imports and the economic recovery lost some momentum
• Argentina: the country’s offer to exchange $335 million of defaulted Brady bonds moves the government closer to selling international debt for the first time in a decade