Bond Outlook by bridport & cie, May 11 2011

In the space of only a week, the prices of many commodities have fallen sharply, and then, to varying degrees, staged similarly dramatic recoveries, causing a modest bounce in the USD, and a decline in Treasury yields. We see these events as short-lived “saw-tooth” movements in the secular decline of the dollar and the long-term appreciation of commodity prices, as well as a reminder of the inherent volatility of commodities when the financial muscle of speculators is so much greater than those who use the markets for conventional hedging purposes. Since we still expect a steepening of yield curves due to borrowing both by the US Treasury and by “Federal” Europe through the future European Stability Mechanism, the decline in long-term yields is best seen as an opportunity to shorten durations.

The debate over whether Greece and other euro zone peripherals will restructure or not continues (a departure from the euro zone seems to have been dismissed). However, the views that we have developed in recent months still hold:

• the strong members of the euro zone, led by Germany, have the means and the will (at government, if not popular level) to bail out the prodigals in the short term
• their motives have more to do with protecting the EUR and their own banks rather than anything more altruistic !
• Greece however cannot ever pay back its debts at 100%, therefore some sort of haircut for its bondholders is inevitable
• European authorities and the IMF will do whatever is necessary to avoid a “credit event”
• haircuts are likely to be instigated via “voluntary” or “soft” restructuring such as tender offers by the issuer
• at least some of the peripherals’ debt will be bought up from the market at distressed prices, using funds raised by bonds issued at the EU level by either the European Financial Stability Facility or its successor, the European Stability Mechanism

We would like to reflect (with acknowledgement to Time magazine) on the slow movement away from the USD as the world’s dominant reserve and trading currency.