Bond Outlook by bridport & cie, December 21 2011

For this last Weekly of 2011, the dark economic clouds have a couple of silver linings:

• lower yields in the auction of new Spanish debt and a sense that the ECB’s “LTRO” ( Longer-Term Refinancing Operations, i.e. 3-year loans to banks) are adding traction
• improvements in employment and housing starts in the USA

In addition, we have found the bond market to be unusually liquid for this time of the year. Let there be no misapprehension however: the euro crisis is far from over, and will only be so when a federalised structure for the euro zone is established.

We have given our own definition of a federalised structure’s three defining pillars: a finance ministry, Eurobonds, and a central bank working in conjunction with the said ministry. We have also suggested that when Merkel speaks of political union, she is using a synonym for a federalised structure. However, since she, for the time being, appears to oppose all three of our defining pillars, we have to question our own understanding of her objectives.

An analysis of her recent declarations suggests that her definition of political union is a pact to fine countries exceeding their budget limits, the absurdity of which would be laughable if not so tragic. Yet the incongruity of Merkel’s words and actions raise some intriguing questions, such as:

• is she burying her head in the sand by denying the need for German leadership, and financing of a federal system? We think not, as she is far too smart for such a level of denial. She may however be acting the part to protect her domestic political support
• is she deliberately dragging her feet to slow down the process of federalisation, for a mixture of domestic politics and an unwillingness to let the prodigals off the hook of their austerity programmes?
• has she done a quiet deal with the ECB to agree to the LTRO programme to bail out the banks, but without the Central Bank breaking the EU law in buying sovereign bonds in the primary market?
• has she brought the IMF into the sovereign bail-out structure as a way around that same EU law?
• is she quietly exasperated with the outbursts of Sarkozy and other French establishment figures, and wants the UK back into the negotiations to obtain more balance (and, dare we suggest, financial input of the second largest shareholder of the ECB)?

Answers will be slow in coming, but of one thing we are sure: she does not want the break up of the euro zone. That should mean that she will, with apparent reluctance, make a step towards her “political union” at every new stage of the euro crisis, of which there will be many more. These will be followed by further European summits, each one billed as the final solution to the crisis, and each falling short of its billing, making financial markets still more sceptical.

We have long recommended the lower-end of investment grade corporate bonds over both bank paper and sovereign debt. However, when the FT starts calling corporate bonds “the new haven”, it might be sign of a haven becoming overcrowded. A few days are now needed to see whether the silver linings referred to in our opening paragraph flourish or wither and that will be the central theme of our next Weekly, planned for the 4th January 2012. We send all our readers our best wishes; may the peace of Christmas be with you all.

Macro Focus

USA: mortgage rates dropped to the lowest level on record as investors sought the relative safety of US Treasuries. Applications for unemployment benefits fell to a three-year low. Consumer confidence may be rising. Whilst data support the view of a strengthening economy, credit markets continue to react to events in the euro zone; correlation between sub-investment grade bonds and the euro currency has risen to near the highest level on record

ECB: leverage at the central bank looks set to continue rising from a record 30x. The ECB’s total assets have risen to €2.46 trillion, driving the ratio of capital to reserves above levels reached during the 2008 global financial crisis. The ECB, supported by some European leaders, has been actively urging banks to take up 3 year loans introduced at their last meeting, and to dismiss any stigma attached to using the facilities. Banks may have no choice as liquidity and interbank lending remain concerns in the euro zone, the Euribor OIS 3 Month spread made a new recent high earlier this month

Spain: banks’ borrowings from the ECB increased by the most in more than a year, with increasing bad loans and lower lending and deposits. Spain’s overall public debt load rose to €706 bln Euros in Q3 from €703 bln in June. Government tenders of bills and five year bonds over the week were well received and borrowing costs fell

Germany: the Ifo institute significantly reduced its 2012 economic growth forecast to 0.40% from 2.30% and lowered its forecast for this year to 3.00% from 3.30%. The Government looks set to overshoot its 2012 borrowing target as the growth outlook worsens and the cost of bailing out banks and troubled sovereigns rises. Nevertheless, business confidence unexpectedly rose for a second month in December

UK: Moody’s signalled that the deteriorating growth outlook and public finances could affect the UK’s AAA rating. Consumer confidence rose from a record low, a Nationwide index of sentiment rose to 40 from 36, which was the lowest level since the survey began in 2004. Retail sales unexpectedly rose to a seven-month high, despite the BoE’s quarterly bulletin reporting households’ cutting back on spending, with 56% of households reporting lower disposable income

Switzerland: economic growth is expected to slow into 2012 as the franc’s appreciation, and falling global demand, hurt exports, according to the KOF Economic Institute. They anticipate the economy to expand 0.20% next year and 1.90% in 2013. Producer and import prices fell for a seventh month