Bond Outlook by bridport & cie, August 10 2011
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Bond Outlook by bridport & cie, August 10 2011

The best hope now is that the ECB stop gap measures work, that federalisation of the euro zone advances and that the recession is “L-shaped”, not a double-dip “W”.

What we, in 2008, called an L-shaped recession, and what Pimco, in 2009, called the “new normal”, (both concepts long denied by official entities), has now been recognised as correct description by the Fed. A mere “L” might actually be optimistic as the economy moves so close to “W”, i.e. a new recession. Stock markets stopped declining after the Fed announcement but the respite was short lived. The recovery of the sovereign bonds in the euro zone appears to be a little firmer. The alleged change of policy of the Fed in announcing at least two years of low interest rates is only a confirmation of what has long seemed obvious, viz, that the short-end rate is anchored near zero. If this announcement provides a new base for even a modest “new normal”, the world can rejoice.


Switzerland is helpless in front of the tsunami of funds seeking a haven. There are likely plans afoot to introduce taxes and/or negative interest rates on CHF accounts held by foreigners, but the CHF will return to reasonable levels only when faith in the EUR returns. That can happen only with federalisation dominated by Germany. That may please no one, not even the Germans, but there is no alternative.


The reluctance of the German parliament to support centralised fiscal structures, or to let them grow to a dimension commensurate with the problems posed by Italy and Spain, has meant that the ECB has had to act in ways beyond its basic remit. The parallel with the USA is striking: the Treasury has proven incapable of appropriate fiscal policies, so the Fed has tried – with limited success – to use monetary measures to prime the economy.


Both the Fed and the ECB (in buying Italian and other sovereign debt) are practising quantitative easing. However, the parallel breaks down with regard to motive. The Fed is trying to revive a broken economy; the ECB is seeking to save the EMU. We see the ECB moves as one leg of the coming federalisation, the other being a euro zone ministry of finance.


We have recently questioned the possibility of growth and austerity going hand in hand. The UK illustrates the point. Its austerity programme has reassured bond markets (AAA rating, CDS rates dropping below Germany’s!), but at the cost of dismal GDP growth and riots. The civil unrest will be brought under control, but is a clear signal to the Government that cutting police forces and community services has consequences beyond mere economics.


Many aspects of the current bond market are a reminder of the period post-Lehman. Banks are reluctant to lend and distrust each other. Corporations can issue bonds, but have to pay rising coupon rates. Given the already high levels of cash on corporate balance sheets, and a reticence to invest, it is no wonder that few are choosing to return to the markets.


The reluctance of corporations to borrow would provide an answer to the enigma of long-term interest rates not rising when governments are borrowing so heavily. We envisaged governments competing with the private sector for funds. However, given the parlous state of economy, it is little surprise that the private sector is choosing not to compete for funds.


In the USA, a moral dimension is belatedly entering the arguments about indebtedness. Professor Kotlikoff of Boston University speaks of “generational balance” (or rather, imbalance) to describe how the current older generation is robbing the younger generation by leaving it with huge levels of debts. He suggests that the younger generation take serious action to stop the rot. While it is unlikely that the English rioters are listening to Kolikoff, their action illustrates his point all too well !


Market Focus


  • USA: in July the jobless rate edged lower whilst wages rose. Payrolls rose by 117,000 after an upward revision for June to 46,000. However, service industries expanded in July at the slowest pace since February 2010. The Fed downgraded growth estimates and suggested an overall deterioration in labour market conditions. They noted that inflation has moderated and that longer term expectations remain stable, warranting exceptionally low levels of fed fund rates until mid 2013. There was also a hint of possible further quantitative easing
  • UK: expectations for GDP growth this year are now at 1.3%. Manufacturing fell in June by 0.4% from the previous month, when it rose 1.8%. Shop-price growth slowed to 2.8% last month as food inflation eased and retailers offered discounts to attract shoppers. However, producer prices rose by 0.20% on the month and 5.90% on the year.
  • Europe: measures that gauge the level of European banks’ reluctance to lend to one another are approaching levels unseen since the aftermath of Lehman’s collapse. The ECB began purchasing Italian and Spanish bonds resulting in a sharp move lower in yields on the two countries paper. The purchases could eventually reach €850 bln. Markets see the move as a necessary to contain the sovereign crisis but likely to renew political fault lines
  • Spain: economic growth slowed in the second quarter, GDP expanded 0.20% from the first quarter, when it grew 0.30%
  • Germany: industrial production declined 1.10% from May, when it rose a revised 0.90%. However, factory orders rose for a third month in June, increasing by 1.8% from May
  • Switzerland: the SNB unexpectedly cut interest rates and said it will increase the supply of francs to money markets to curb the “massively overvalued” currency. The bank lowered its target for the three- month Libor to “as close to zero as possible” from 0.25%. Weakness in the Swiss franc was short lived as market volatility increased the currency’s appeal as a safe haven
  • Australia: the RBA slashed its 2011 growth forecast and raised the outlook for inflation, signalling it may extend an interest-rate pause into a second year on concern the global economy may stall
  • China: inflation accelerated to the fastest pace in three years in July, limiting the scope for monetary easing to support growth. Consumer prices climbed 6.50% from a year earlier as food costs surged

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 10, 2011

Dr. Roy Damary

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