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Bond Outlook by bridport & cie, January 18 2012

Europe seems to have joined the USA in showing a few silver linings in the dark economic clouds. The ECB’s massive bank lending may be thanked. For increased liquidity.

While the economic silver linings in the USA continue to brighten (notably on the industrial front where labour costs have become more competitive), positive signs have also begun to emerge in Europe. Whilst a return to serious growth is far from evident, as in the USA, a degree of stabilisation appears to be taking place. The cost of borrowing for Spain and Italy has declined, and inflation is slowing. The S&P downgrades have been shrugged off, and S&P is losing credibility, especially with its downgrade of EFSF.


The main force behind these benign developments is the ECB, although the credibility of Mario Monti in Italy surely helps. (Incidentally Monti is the exception in welcoming the S&P reports.) The ECB’s massive loans to banks have helped stabilise the banking sector, without doing much yet to improve lending, or encourage a renewed interest in purchasing sovereign debt. It appears that the nearly EUR 0.5 trillion of borrowing by banks from the ECB had simply been re-parked at the central bank, awaiting further deployment. According to Draghi, however, the banks borrowing from the ECB are not those depositing with it. That suggests that the loans are moving around within the banking sector and are not yet being deployed in such a way as to encourage economic growth. Maybe stabilisation, which is all that Draghi claims, is the best that can be hoped for while the Greek (and Portuguese) problems are weighing so heavily.


There is nonetheless a very positive impact of bank stabilisation on the fixed-income markets. They have returned to almost normal liquidity, and to a healthy level of issuance by corporations (if not by banks). One development is that industrial corporations are using floating rate notes to borrow cheaply. Historically, FRNs have been almost exclusively issued by banks. However, while investors are still somewhat suspicious of bank debt, they are welcoming the rare opportunity to buy corporate FRNs alongside the more traditional bank floaters.


Greater issuance of corporate bonds is essentially a healthy development. Two aspects nevertheless mute the rejoicing: many of the funds being raised are being used for share buy backs instead of productive investment, and small and medium sized companies are still devoid of normal borrowing facilities.


Will the March deadline for the next tranche of Greek bond maturities, which, assuming agreement is found, will certainly involve a massive haircut, be considered a default event? Probably not, for the usual reason that the consequences for the CDS market would be so serious that the authorities concerned will do all that is possible to claim “voluntary restructuring”. It is a little like the dominant argument for Greece staying in the euro zone: the cost of leaving is so severe that it is better to pay whatever price is required to keep Greece in. A legal paradise beckons.


To our enigmatic question of last week (when will inflation take off?), we would add another for readers to dwell on. What on earth does Merkel mean by claiming that “we are creating a fiscal union”. We had assumed it was synonymous with a “federal structure”, but her silence since early December questions that assumption. As Monti points out, he can “sort out” Italy, but only Merkel, albeit with other European leaders, can “sort out” the euro zone. Lack of clarity really does not help.


Macro Focus

USA: consumer confidence, as measured by the UoM consumer sentiment index, rose to the highest level in eight months. Wall Street’s 21 biggest bond-trading firms hold more U.S. Treasuries than corporate securities for the first time ever: $74.7 bln of Treasuries as of 28th December, compared with $61.1 billion of corporate debt


Europe: S&P downgraded 9 euro-zone nations including Italy, Spain and Portugal and with France and Austria stripped of their AAA status. Market reaction was muted, suggesting much of the move had been priced in. Thus Spanish borrowing costs plunged to an average 2.049% at auction of 12 month paper, compared with 4.05% on Dec. 13. It sold 18-month paper at 2.399%. French borrowing costs also fell at the country’s first bill sale after the downgrade (one-year notes at a yield of 0.406%, down from 0.454% on Jan. 9. The EFSF issued 6 month debt for the first time, selling €1.5 bln of securities at 0.27%, one day after it lost its top credit rating


Euro-zone liquidity: the wholesale markets for bank debt appear to reflect some easing of concerns. The Libor-OIS spread has began to trend lower suggesting the ECB’s liquidity injection is helping to alleviate the reluctance of banks to lend to one another. Spanish banks’ average borrowings from the ECB rose in December to their highest level in 18 months. Borrowings reached €118.9 bln from €98 bln November


Germany: the economy contracted around 0.25% in Q4 according to the Federal Statistics Office, suggesting the country may be on the brink of recession. Nonetheless, investor confidence rose the most on record in January, bringing hope that the worst of Europe’s sovereign debt crisis may have passed. The ZEW index of investor and analyst expectations surged to -21.6 from -53.8 in December. In reaction to the downgrades for European sovereigns Merkel called for a swift adoption of the proposed fiscal compact and said she would listen to calls for legislation to protect institutional investors from being forced to sell bonds when their ratings were downgraded


Greece: the government is running out of time to avoid becoming the first euro nation to default after talks with lenders stalled ahead of a 20th March bond payment of €14.5 bln. Prime Minister Papademos is meeting a group of private Greek bondholders to discuss forgiving at least half of the nation’s debt in the euro area’s first sovereign restructuring


UK: shop-price inflation slowed in December to the lowest in almost 18 months: retail prices rose 1.70% from a year earlier, down from 2.00% in November. Inflation, as measured by all consumer prices, slowed to its lowest pace in six months, an annual rate of 4.20% compared with 4.80% in November. Factory output prices fell in December for the first time in 18 months, declining by 0.20% from November

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