Bond Outlook by bridport & cie, March 7 2012
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Bond Outlook by bridport & cie, March 7 2012

We see this as a major reassertion of sovereignty and democracy. It will not be the last “rebellion”.

For some weeks, we have been questioning the practice of belt tightening in countries which spent so much more than their means. Our question has not been about the need for belt tightening, but about the speed and severity of the required austerity measures. The need is there in almost all Western countries, whether they be in a currency union or not. Moreover, the need for austerity is recognised not just at country level, but also at lower levels of government such as states and provinces in North America. We obtained some insight into the situation in Ontario during recent travels. The Province has decided to control its budget deficit by cutting back on expenditure, but in many ways faces the same problems as those found in the euro zone: no possibility of devaluation, but burdened with a currency whose exchange rate reflects the economic strength of other parts of a currency union (the CAD). Compare German economic strength versus less competitive countries in the euro zone, and the wheat, oil and gas dependent Western Canadian provinces versus the industrial East.


The call in all these cases is, “austerity by all means, but not to the point of strangulation!” There are at least three causes for this cry to become much louder:


  • First, the “street” mass demonstrations, sometimes violent
  • Second, the economic argument that excessive tightening reduces government revenues, and starts a vicious circle of falling GDP
  • Third, a growing sense that an overtly dictatorial Germany is unacceptable to sovereign countries


Spain epitomises this third reason. The newly elected government has simply rejected the timetable imposed by the EC. It fully accepts the need to move towards budget balancing, but not at a rate they believe will result in economic stagnation (or worse). A change in the French Presidency is likely to lead to a similar reaction in France. Other such “rebellions” are likely as governments fall one after the other. We rejoice that democracy is reasserting itself, and believe that a slower, but steady, move to budget balancing is also better economics.


Clearly the ECB, with its long-term refinancing operations to banks, has acted where euro zone politicians have prevaricated, and against the wishes of the Bundesbank. LTRO has given the euro zone time to address structural problems in individual countries, and to move towards the federal structure needed for long-term success of the euro zone. Why is Germany dragging its feet on federalisation? How can Merkel speak of “fiscal union” and then do nothing to bring it about? The answer lies somewhere in German domestic politics. Can she hold off the threat of electoral defeat, and then make the moves she knows have to be made for the good of the entire currency union?


Let it not be overlooked that two euro zone countries, Ireland and Italy, are dropping off the worry list, and seem to be putting their houses in order – slowly and steadily!


Let us finish with an interesting point raised by Axel Merk. The old days have gone when the Fed controlled only the short end of the USD yield curve. The Fed now buys bonds all along the yield curve, with the admitted purpose of controlling its overall shape. The attenuation of market forces on the yield curve means that the bond markets no longer give such clear signals to the Fed about interest and inflation outlook. Merk therefore suggests that the Fed is flying blind. At least, he observes, the bond market is still able to signal its views to the ECB and other European authorities, and has caused the ECB to reinforce the banking sector and individual countries to begin budgetary rebalancing.


This view echoes our own that both the USA and Europe recognise the need for budgetary balancing, but only Europe is actually doing something about it.


Macro Focus

USA: service industries, representing about 90% of the economy, expanded in February for a fourth straight month, to a yearly high. The ISM non-manufacturing index rose from 56.8 in January to 57.3. However, factory orders fell, suggesting manufacturing is cooling. Wage growth had its biggest 6 month gain in 5 years in the second half of 2011, which should lead to stronger consumption this year


Europe: the euro-zone economy contracted by 0.3% in Q4, compared to Q3. Exports fell 0.40% after a 1.40% gain in the previous three months. Services output shrank more than expected in February, led by Italy and Spain; an index of purchasing managers in the services industry fell from 50.4 in January to 48.8


European liquidity: the reluctance of banks to lend to one another fell to the lowest level in 7 months, helped by the ECBS second allotment of cheap 3 year loans. The Euribor-OIS spread has fallen from a high of just over 100 bps in early December to 58 bps. The ECB stated that overnight deposits soared to a record €776.90 bln following its second tranche of 3 year LTROs. The central bank’s balance sheet is also at a record size at over EUR 3 trillion


Germany: Retail sales unexpectedly declined in January by 1.60% from December, when they had increased 0.10%


Spain & Portugal: the Spanish Prime Minister Rajoy defied the EU by raising Spain’s budget deficit target for 2012, citing concerns that a deepening economic slump will be counterproductive. After the European summit in Brussels, he announced a new estimate of 5.80% of GDP compared with the previously agreed 4.40%. In contrast, Portuguese Prime Minister Coelho, said Portugal will “absolutely not” alter its deficit goals pledged in return for a European Union led aid package last year


Greece: European leaders are shifting their focus away from the budget cutting and committing to a pro-growth agenda as the area slips into recession. Markets appear unconvinced with many commentators worried that a third bailout for Greece may be necessary. The ISDA said CDS has not been triggered by the ECB’s exchange of Greek bonds for new securities exempt from losses taken by private investors.  However, a CDS payout could still happen if Greece uses collective action clauses on investors who refuse to take haircuts. Thus far, around 20% of private holders have declared their intention to participate in the restructuring


UK: the PMI services index fell from 56 in January to 53.8, as sales growth slowed and some companies noted a “challenging” environment. Retail sales fell for a second month in February. Sales at stores open at least 12 months, measured by value, fell 0.30% from a year earlier, following a similar decline in January. The British Chamber of Commerce suggested the UK government should bolster aid to companies to help them deal with the impact of Europe’s debt crisis. The Chamber lowered its 2012 growth projection from 0.80% in December to 0.60% and pushed out its forecast for the first interest rate rise to the end of 2013


Switzerland: Retail sales rose 4.40% in January from a year earlier, having gained a revised 1.70% in the previous month. It was the strongest increase since June 2011


China:  the government reduced its economic growth target to 7.50% from an 8% target in place since 2005. They also set a higher target for inflation in 2012 than analysts expected (4%), leaving room for fiscal and monetary stimulus and an easing of government controls on the cost of resources

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