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Bond Outlook by bridport & cie, November 23 2011

At the moment, bond market yields are being driven not by economic fundamentals, but by mass psychology and political issues. How long can this continue?

At the moment, bond market yields are being driven not by economic fundamentals, but by mass psychology and political issues. How long can this continue?


Since the beginning of October, the political crisis in the Euro-Zone has created, once again, a divergence between prices in the bond market and those in other securities markets such as equities and oil: bond yields have stagnated while equities (even allowing for November’s declines), and oil, have rebounded (especially in October). This is not the first time such a divergence has emerged in the past two years; in fact, it is merely the continuation of a trend that began with the start of the sovereign debt crisis. Since March 2009, the S&P 500 index has rebounded 75%, but the yield on US 10-year Treasuries has fallen from 2.9% to 1.9%. Normally, the two asset classes are inversely correlated: yields increase while equities perform.


The current equity-bond divergence is probably the result of fundamental differences in the approach of fixed income desks on the one hand, and equities desks on the other. Fixed income analysts are traditionally moved by a top-down approach, driven by the macro environment and government solvency. Equity analysts, by contrast, are typically focused on a bottom-up approach – that is to say they form views based on corporate and sector fundamentals. So long as bottom-up and top-down news conflict, then equity and fixed income markets could continue to send out opposing signals.


However, while uncertainty has remained elevated in the last few months, economic and corporate fundamentals have, on the whole, been good – not universally so, and certainly significantly better in America than in Europe – but good nonetheless. As a consequence, the view from the bottom, as it were, is not as dark as that from the top.


* In the US, numerous macro indicators have surprised to the upside over the past few weeks. In August and September, 84 indicators declined from the previous month and 80 improved. Since October, the trend has been much more positive, with only 42 ‘negative’ data versus 60 ‘positive.’ The volume of good news coming from the Euro-Zone has also increased, although not enough to reverse the trend.


* Corporate earnings data has also been surprisingly good. Globally speaking, sales were up this quarter, and once again, earnings were better in the United States than in Europe. It is significant that cyclical sectors, such as oil and gas, basic materials, technology and consumer services have still realised notable sales growth.


Because the fixed income market is dominated by sovereign, quasi-sovereign and financial issues, such positive credit news has not been sufficient to reverse the depressed atmosphere on bond markets. Such a transformation will require an end to the sovereign crisis, and the associated market fear. It is difficult to say when this will happen, as it depends on so many factors, but recently some important dominos have fallen. The sovereign crisis has been largely transformed into a political crisis, and already seven European countries have thrown out their governments: the five PIIGS and two core countries, Finland and Denmark.


It is important to keep in mind the different approaches which have led equity-bond divergence, as they are also the reason for the market volatility, and this disparity may continue. However, when Europe’s political crisis ends, or at least abates, the positive fundamentals of the past few months should begin to feed through into bond yields, and risk aversion should fall rapidly.

Macro Focus

Euro zone: Yields continue to rise for Euro zone countries. Despite the landslide victory of the austerity-promising People’s Party on Sunday, Spain yesterday paid a yield of 5.11% for three-month notes, up from 2.29% a month ago. The spread between French and German 10-year issues is the highest for twenty years. In November, Eurozone consumer confidence dropped to the lowest level since August 2009 down to -20.4 from -19.9 in October.


ECB: Mario Draghi, in his first major speech, argued that the ECB would lose credibility if it departed from its primary role of keeping prices stable and embarked on large-scale bond-buying.


USA: The bipartisan ‘supercommittee’ failed to agree a compromise on $1.2tn of budget cuts and spending rises: the same figure will now be automatically cut from entitlement and defence spending. The government downgraded real Q3 GDP growth from a 2.5% annualised figure to 2.0%. However, industrial production rose to 3.92% YoY in October, up from 3.10% in September, and CPI fell to 3.5% YoY in October, down from 3.7% in September.


UK: The government announced that the Treasury is preparing to buy billions of pounds of corporate bonds and securitised loans of small companies, and that £400m would be made available for housebuilding subsidies. Britain’s budget deficit in October was £6.5bn, down from £7.7bn in the same month last year.


SNB: The Bank agreed to make a 1bn CHF annual dividend to the federal and cantonal governments 2011-2015, so long as profit remains after currency trading. So far this year the Bank has made a 5.83bn CHF profit.

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