Bond Outlook by bridport & cie, June 15 2011

If it were a programme to engender the affections of the public, the behaviour of the banking industry over the last few years could hardly be deemed a roaring success:

• firstly, develop highly risky mortgaged-backed securities and sell them (admittedly to many willingly blind buyers) as very safe investments
• on the realisation that these securities were not all they seemed, either:
  • get out of owning them as quickly and as quietly as possible
  • or believe one’s own bs and keep the securities until they crash
• persuade governments that the only way to save the banks in the second category, and therefore the economy, is to pump in vast amounts of equity and loan capital
• enjoy a risk-free return to profitability by using the low-cost government (read “taxpayers’”) money to buy Government bonds further along the yield curve at a higher return
• increase already high levels of remuneration of leading bank executives by several tens of percent
• when an Independent Banking Commission (IBC) recommends “ring-fencing” retail banking from investment banking, threaten the Government with moving to a new, less punitive, jurisdiction

The programme, as followed in the UK, but echoed elsewhere, not only alienated the public, but is also akin to a declaration of war on a government determined to pay heed to the public reaction. Cynics would add that a government forcing through unpopular austerity needs to take whatever moves are available to placate its electorate. Thus the Chancellor, George Osborne, has now come down firmly in favour of the IBC’s recommendations, supporting full separation of investment and retail banking.

In the meantime, Basel 3 is moving forward with its significantly greater demands for bank capital. Governments (which lest we should forget, are at least partially cognisant of public opinion) appear to welcome the proposals, and appear ready to enact laws accepting (or as in the case of Switzerland, exceeding) Basel 3. Banks are also recognising the need to increase capital, and, despite the dubious success of their recent creativity, have come up with new ideas like the “CoCo” bonds in order to achieve it. These have got off to a poor start after a debt-for-equity swap at the Bank of Ireland pushed the share price down.

Our suspicion is that Osborne is prepared to call the UK banks’ bluff, because he has every confidence that the UK is not alone in wanting to rein in banks in the light of the events described above.

The move to banking separation, and the advent of Basel 3, mean one thing: less capital will be available for lending and market-making. The latter is already apparent in our trading for clients. Our experience is focused on Europe, where sharply reduced liquidity is apparent across the board. Market-makers are not updating prices and inventories are low, so screens do not reflect true market reality and thus completing trades is a struggle (enter your friendly broker!). Whether this squeeze is mainly down to the coming liquidity requirements, oft repeated ‘seasonal factors’, or in response to bank’s recognising potentially greater losses from the ever-deteriorating position in peripheral European debt, will become apparent over coming months.

Despite Bernanke’s view that ending QE2 will have little effect on financial markets, we would link the current flight to quality (overweighting cash and fixed-interest, and favouring higher rated bonds over equity) partially to a shortage of quality issues in the market. It will be intriguing to watch the impact of the US Government having to once again depend on the open market to raise funds, especially when China is more interested in reducing its holdings of T-bonds than in expanding them, and Japan has greater domestic concerns.

Market Focus

• US: sales at retailers fell by a modest 0.2% in May. Business optimism declined from a record high in the last quarter

• Fed: Bernanke: the “frustratingly slow” US recovery warrants sustained monetary stimulus but growth will gain speed in the second half of the year

• Germany: the Bundesbank raised its forecasts for GDP growth to 3.10% this year and 1.80% in 2012. Industrial production declined by 0.6% in April, the first fall in four months, the drop being led by construction output

• Spain: the Government declined to raise VAT and cut social security contributions as recommended by the European Commission as a means to reduce non-wage labour costs

• Greece: S&P cut Greece’s credit rating to CCC with negative outlook as European finance chiefs begin the final stage of hammering out another Greek rescue plan

• UK: inflation expectations fell last month for the first time since February 2009. Consumers expect prices to increase 3.90% over the coming year. Nonetheless, CPI held at 4.50% in May, the fastest pace since October 2008

• BoE: argument continues within its ranks as to whether inflation needs taming by tightening

• Switzerland: new economic forecasts differ. The KOF Swiss Economic Institute puts this year’s growth at 2.2% instead of their previous 2.0% forecast, whereas the Government lowered its forecast for 2012 growth from 1.9% to 1.5% and said a further appreciation of the franc poses risks for the future

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.

June 15, 2011

Dr. Roy Damary