Bond Outlook by bridport & cie, August 17 2011

If there is to be no default and a break-up of the euro zone, then “There is no alternative to Eurobonds” says Peter Bofinger, economic adviser to Merkel. Apparently she does not pay much attention to his advice, as Sarkozy and she do not wish to see bonds issued by the Euro zone as a whole until the end of a long process of what they call “true economic governance”.

It is easy to dismiss their position as a sign of indecisiveness and weak leadership. Certainly financial markets take this view. It may, however, be appropriate to look at the pressures causing such an unsatisfactory outcome to their meeting.

It is now accepted wisdom that a large degree of fiscal and transfer union is required for the euro to survive and flourish. This implies centralised control and supervision of both spending and of revenues, as well as borrowing, and nothing less. The borrowing has to be supported by the strongest economies, notably by Germany. In addition, there is an obvious argument that a combined market for all euro zone sovereign bonds would be large and highly liquid, with low interest rates.

Why therefore is there so much hesitation? The first and clear answer is that the electorates will not stand for it. To express the problem anecdotally, “do you really think the German population will agree to pay for Greek pensions?” History also has a role to play. Inevitably memories of Germany’s last attempt to dominate continental Europe disturb the European populace, and, equally importantly, the Germans themselves.

It is very much as if an irresistible force (the desire to make the euro experiment succeed fully) is meeting an immovable object (the resistance of European populations to loss of sovereignty, and further fiscal and economic integration). Sarkozy and Merkel are therefore looking for a fudge, i.e. a form of words that will gradually allow the immovable object to budge. Whether this is a sign of weak leadership or political realism, history will tell.

The relative market calm this week, including the Swiss franc backing off from its highs, is unlikely to last. The euro zone problems will have to be resolved one way or the other. In the USA also, serious steps to budget balancing must eventually be taken.

Our own clients’ attitudes reflect this sense of calm before the new storm. Those selling their holdings are very definite, those buying are moving with much greater caution.

There is a little good news in Europe: Ireland is making steady progress in balancing its budget and strengthening its banks. Lagarde, in her new position as Head of the IMF, is actively suggesting that overly aggressive austerity programmes (was she thinking of the UK?) may do more harm than good. She recommends short-term stimulus with medium-term fiscal consolidation. That is easier said than done.

Market Focus

• Euro zone: vulnerability of the recovery has increased because of Europe's expanding sovereign-debt crisis, dixit Zoellick. While European GDP disappointed CPI inflation remained high. The CPI in Germany rose to 2.6 % from 2.4 % in June. Spanish inflation remains unchanged at 3.1%

• USA: the likelihood of the U.S. slipping back into recession doubled in the past three months, to a 30% chance (USA Today). However, retail sales in the U.S. climbed in July by the most in four months and for unemployment insurance claims payments fell last week to a four-month low. The trade deficit increased in June to the highest level since October 2008 as a decline in exports exceeded that of imports

• Italy: the government will adopt EUR 45 billion in deficit-cuts in the next two years to balance the budget in 2013 as it tries to convince investors it can tame the region’s second-biggest debt

• ECB: the overnight lending rate to banks jumped to a three-month high, a sign some lenders may need emergency cash

• UK: inflation accelerated in July to 4.3 % pa vs. 4.2 % in June, squeezing those who are already facing government spending cuts and slower economic growth. BoE’s King said headwinds buffeting the U.K. economy are intensifying “by the day”, opening the door to more stimulus if the outlook for growth deteriorates further

• CDS: spreads on Bunds are currently higher than on Gilts

Disclaimer
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.

August 16, 2011

Dr. Roy Damary