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Bond Outlook by bridport & cie, January 11 2012

Rejoice in the improved employment situation in the USA, but do not confuse breathing space provided by cheap money with a real solution to economic weakness based on rebalancing.

A more favourable period for the US economy and the USD is now underway, and throws into sharp contrast ongoing concerns about the euro zone, and Europe as a whole. This period of “Advantage America” is likely to last for some months, however neither Europe nor the USA should expect to see significant growth during a multi-year phase of deleveraging and shift in economic power from the developed to the developing world.


On both sides of the Atlantic, the inevitable need for deleveraging at government and household level is recognised. The difference is that European leaders are doing something about it, while political deadlock on deficit reduction remains in the USA (and is likely to be exacerbated as we move toward November’s election). We would go so far as to assert that what recovery there is in the USA depends on precisely the same approach that led to the crisis of over-indebtedness in the first place: a massive supply of cheap money. There is no denying that quantitative easing, aka printing money, is indispensable to head off economic collapse. However, if temporary relief, or “time to breath”, is confused with long-lasting restructuring, the USA will continue to lurch from crisis to crisis until a permanent, and painful, solution is found.


The same criticism applies to the euro zone, where a totally inadequate move to a new accord has given breathing space, but not made more than a timid move to a federal structure. It can even be debated that the current respite in euro land is more the result of the ECB mimicking the Fed with its cheap bank loans than any progress being made on a new euro accord.


The hesitation, if not refusal, of European banks to use the cheap loans from the ECB to buy sovereign debt and lend to enterprises is disquieting. If the banks do not change their minds, the resentment of banks amongst politicians and the public can only grow. Nevertheless, it is early days to see what banks will do with the three-year loans being made available. What is clear is that the demands for additional equity, and fewer high-risk assets, means that bank lending to businesses will remain constrained. For large corporations, this may scarcely matter as they can access the bond markets, but this is not the case for most small and medium enterprises. We rather expect some government moves to facilitate lending to SMEs, which is already the subject of debate in the UK.


The squeeze on banks will reinforce the lack of liquidity in bond markets, curtailing as it does market making and other risk bearing activities.


There are also two new threats on the horizon:


  • Sarkozy wants to introduce a tax on financial transactions, if necessary, for France alone. That appears incredibly self-destructive and potentially damaging for the French economy
  • The confrontation of the West with Iran is likely to push Iran into a self-destructive attempt to close the Hormuz Straits, with at least a short-term impact on oil prices


Notwithstanding these immediate concerns, a vital longer-term question remains open: when will deflation end and inflation begin? Inflation is held at bay only by economic weakness. Recovery is a long way off, but when it comes, inflation will be the price to be paid.


Macro Focus

USA: payrolls increased more than forecast in December and the unemployment rate fell  to an almost 3-year low of 8.50%. The number of people working a full week rose to 113.8 mln, the most since February 2009, while the number of people working fewer hours fell to 8.1 mln. Factory orders rose by the most in 4 months


Europe: inflation slowed for the first time in 5 months in December, the rate fell to 2.80% from 3.00% in November. Confidence in the economic outlook fell to the lowest in more than 2 years. The ECB took a record amount of overnight deposits, Euro-area banks placed €455.3 bln with the central bank. Fitch stated that Italy faces a “significant chance” of a downgrade


Portugal: the central bank said it expected the Portuguese economy to contract more than previously forecast in 2012 as the government cuts investment and consumer spending drops. GDP is now expected to fall by 3.10% this year


Germany: retail sales unexpectedly fell 0.90%. Factory orders dropped the most in almost 3 years falling 4.80% from October, when they had surged a revised 5.00%. Industrial output declined in November as factories produced fewer investment and consumer goods. Production fell 0.60% from October, when it rose 0.80%. However, German exports rebounded in November, rising 2.50% from October


Greece: the government is in final negotiations to persuade investors to write off at least half of its debt. The Prime Minister expects to have an outline for the €100 bln plan next week, when talks on the terms for a second financing deal with European Union and International Monetary Fund officials start. On March 20th government bonds with a par value of EUR 14.5 billion, now trading at about 45%, fall due


UK: the British Chamber of Commerce believe more stimulus from the BoE may not be enough to revive economic growth and that the government must improve companies’ access to credit to aid the recovery. However the BoE’s quarterly credit conditions survey shows that UK banks expect to toughen the criteria on loans to companies and households in the first quarter because of strains in wholesale funding markets. Service industries grew at the fastest pace in five months in December, the PMI Survey for services rose to 54 from 52.1 in November


Switzerland: SNB Philipp Hildebrand resigned as head of the central bank four days after pledging to fight for his job as uproar over his wife’s currency trading undermined his credibility as guardian of the franc.  Swiss unemployment increased to the highest level in 8 months. The jobless rate rose to 3.10% in December from 3.00% in the previous month


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