Bond Outlook by bridport & cie, January 19 2011


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Struggles are emerging between governments nurturing weak recoveries and central banks wishing to dampen inflation. Bond markets may encourage central banks in raising rates, the BoE first, ECB later.

Bond Outlook

Inflation is climbing and, with it, the pressure on central banks to raise rates. The BoE are likely to tighten first, followed by the ECB. The inflation is “cost-push”, arising from increases in the prices of crude, foodstuffs, steel, and the like. It is strange that the USA is not seeing similar inflationary pressure, especially as the USD has weakened so much, but that may just be a matter of time, as the steepening of the USD yield curve suggests.


Higher interest rates are the last thing that governments want while recovery is so fragile. That would suggest a certain tension between European governments and their central banks. Although governments can scarcely admit it, higher inflation does of course carry with it the attraction of reducing debt to GDP ratios. Pay lip service to the official target rate of 2%, but do not insist too much!


If there is a struggle between central banks and governments, it may be resolved by bond markets. They are pushing up longer-term yields, and there will come a point when anchoring overnight rates so low may help increase bank profits, but does little for the rest of the economy. Overall, we expect the BoE to raise its rates sooner rather than later. The ECB will wait as long as possible in the hope that the menace of inflation will dissipate. We do not think it will, and believe that they will have to act within 2011.


When will the USA be forced to face the same issues? Not for as long as the Federal Government can borrow so cheaply. It will take quite severe yield curve steepening before action is forced upon it to be much more serious about rebalancing the Federal budget. Let us however admit that whenever we have thought that the USA must now reverse its path of spending beyond its means, it manages to put off the inevitable still further.


A significant development in 2010, which is becoming even more evident in early 2011, is the growing importance of China’s role in financial markets. We have already seen their contribution to the rescue of the EUR, and it is now lending more to emerging markets than even the World Bank. It has allowed a timid role for the RMB in international trade within Asia. However, the most important news is President Hu’s announcement that the RMB will gradually take on the role of a reserve currency. As we have been proposing for many years, full global rebalancing needs three major zones, the US, Europe and Asia, each with its own leading reserve and trading currency.


Risk appetite in fixed income markets is high, especially in USD. We would question the risk/reward characteristics of low-credit corporates, but believe that sovereign debt in Europe may be closer to a “fair” price. We note that some utilities in peripheral countries are offering attractive bonds.


Market Focus


  • US: Banks have increased lending, reducing the attraction of parking funds in government bonds. The yield curve is steepening. Consumer confidence declined in January to 72
  • Euro Zone: Trichet reiterated that the ECB would raise rates if inflation needed controlling
  • Spain: Banks boosted their European Central Bank borrowings in December to €67 billion, the first monthly increase since July, as financing conditions tightened for lenders. Plans are to sell EUR 93,8 billion in 2011, and initial sales are progressing satisfactorily 
  • Portugal: The Central Bank revised down its projection for real GDP this year from flat to -1.3%, reflecting the impact of the fiscal retrenchment
  • Germany: Inflation accelerated to 1.9% in December, the fastest pace in more than two years, led by higher energy costs
  • UK: Producer prices rose more than economists forecast in December on higher costs for food and fuel. The cost of goods at factory gates increased 0.5 % from November, when they gained 0.4 %. Consumer price inflation reached 3.7%
  • Switzerland: the franc declined against the euro on expectations that policy makers may act to weaken the currency and as an easing of Europe’s debt crisis curbed demand for safer assets
  • Banks: Rabobank has issued for a second time Tier 1 bonds under the new Basel III rules with the book around EUR 5.5 billion for a deal size of EUR 1.5 billion. Coupon for five years 8.5%. Thereafter?
  • Banks: Monte Dei Paschi announced that they will not call two of their T1 bonds due to the ‘extraordinary circumstances attributable to the utmost uncertainty in the current legal and regulatory framework for new issues of capital instruments eligible as Tier 1 under Basel III’

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 19th 2011

Dr. Roy Damary