Bond Outlook by bridport & cie, January 26 2011


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Note well what King of the BoE is spelling it out, echoed by Trichet: an income squeeze in the West is unavoidable. No such recognition by Bernanke in the USA.

Perhaps it takes a central banker, unencumbered by changes of government, to spell out what politicians on both sides of the Atlantic seem so wary of articulating, viz. that the crisis was brought about by overspending and can only be solved by lowering the standard of living in the countries concerned. Mervyn King of the BoE assumed the task this week in a major televised speech. He used the expression “income squeeze”, defined as wages and salaries rising more slowly than inflation, as one of the steps to the UK regaining its international competitiveness, with unavoidable cuts in public spending and a lower Pound also helping to rebalance the UK economy.


He expressed sympathy for countries in a similar position to the UK, but without the option of a weaker currency (for them only greater cuts in salaries can work), and also for savers and people living off the return on their savings. Clearly a return to normal levels of interest rates is desirable for the Monetary Policy Committee. Yet King also justified keeping rates low, even at the cost of exceeding the 2% target inflation rate, by spelling out that the BoE’s remit included letting inflation exceed the target in exceptional circumstances. For him, the crisis and the rise in commodity prices are clearly exceptional.


Whether the MPC will raise rates in March remains unclear, but undoubtedly the decision will be better informed at that point in time (when we will know whether yesterday’s announcement of a collapse in 4th quarter GDP numbers was indeed an aberration, largely attributable to the British weather!) . Nevertheless, a modest rise in bank rates seems likely.


Trichet of the ECB is saying much the same thing as King. The rate of inflation may have exceeded the 2% target because of external cost rises, but the key thing is to avoid “secondary effects”, i.e. allowing wage rises to keep up with inflation. That is the same message as King’s, albeit it expressed in a different manner.


Thus far, our expectation that the European authorities would successfully contain the sovereign debt crisis is proving justified. The need for a long-term solution, by revamping the workings of the Euro zone, remains, but is being addressed. Until recently, we could only describe investing in peripheral country debt as a “punt”, whereas now the entire risk/reward balance, and choosing the most attractive maturities, lend themselves to more conventional analysis.


In many ways, the situation in the US has startling parallels to that which existed before the crisis: the stock market is rising and the GDP expanding. Our own questions also remain largely unchanged, as do our concerns that this apparent recovery is not based on solid fundamentals. Where are the real investments? Has the housing crisis been solved? Is the Federal Government facing up to reducing the deficit? Is the low cost of money a reflection of its huge supply through continued quantitative easing? Why is unemployment so stubbornly high, and ultimately can a country, even a super-power, spend its way out of a crisis which it created by excess spending?


We believe the answers to these questions to be very obvious, and we have often rehearsed them here. Yet the answers to two other questions continue to elude us:


Why is the United States yet to see the inflation emerging elsewhere, and when will it?


When will QE be reversed, and what will happen at that point, when government debt begins to be sold on the open market?


When pondering these issues, we cannot help but note that the practice of a central bank buying the debt of its own government has always led to high inflation (and sometimes, to hyper-inflation). In due course, we still see the USA being forced to accept a “European” solution. We might then see America’s Central bankers, rather than just its movie going public, gain an appreciation of a King’s speech!


Market Focus


  • U.S. the Index of leading economic indicators increased in December. The Conference Board’s gauge of the outlook for the next three to six months rose 1.0 % after a 1.1 % gain in November. Corporate bond issuance continues at a high level
  • Spain: the country is addressing problems in the country’s savings banks, or cajas, which need a minimum of EUR 17 billion Euros in additional capital, rising to EUR 89 billion in a stressed case that assumes they must target a Tier 1 capital level of 8 %
  • Euro zone: after the success of the EFSF bond issue, CDS on Europe’s deficit-ridden nations rallied on speculation policy makers will let governments buy back their bonds at a discount to avoid restructuring their debts.  Central Bank officials retreated from a threat to raise interest rates, saying markets have over-reacted to their change in tone on inflation 
  • Germany: growth in manufacturing slowed in January. However, business confidence rose to a record high as booming exports to Asia and stronger household spending bolstered growth
  • France: the Government auctioned the largest amount of inflation-protected bonds in almost five years: EUR 2.995 billion five-year bonds. Growth in manufacturing slowed in January, but business confidence jumped to its highest in almost three years (108 vs. 102 in December)
  • UK: Q4 GDP came in significantly below estimates (-0.50% vs. 0.50%).  Five year Gilt yields fell 12bps on the news and Sterling deteriorated markedly, most notably against the Swiss Franc. Retail sales dropped the most ever for a December. Sales fell 0.8 % from the previous month, when they rose 0.4 %. U.K. mortgage approvals fell to the lowest level since March 2009
  • Switzerland: investor confidence fell in January: ZEW Index of Investor Confidence to minus 18.4 from minus 12.5 in December
  • China: economic growth accelerated to 9.8 % as industrial production and retail sales picked up

This document is based on sources believed to be reliable, accurate and complete. Any information in this document is purely indicative. This document is not a contractual document and/or any form of recommendation. Expressions of opinion herein are subject to change without notice. We strongly advise prospective investors to consider the suitability of the financial instruments, based on the risks inherent to the product and based on their own judgment. It is not intended for publication. This document may not be passed on or disclosed to any other third party without the prior consent of bridport & cie s.a. © bridport & cie s.a.

January 26th 2011

Dr. Roy Damary