Bond Outlook by bridport & cie, February 8 2012

This week we have a mystery to solve: why has the bond market suddenly become so liquid that it is exceptionally easy to sell almost any corporate bond? In fact, the mystery is wrapped in an enigma in that the stock market is performing well at the same time as the fixed-income market. We offer some hypotheses:

• market makers are closing out short positions established in recent months
• Bernanke’s announcement of the likelihood of three years of low Fed rates have reassured fixed-income investors that the interest-rate risk is minimum
• in Europe, many corporate bonds can be used as collateral to borrow cheaply at the ECB, without having to forego the interest on the bonds deposited
• CDS spreads have narrowed, reinforcing the sentiment that credit risk is much reduced

The attraction of stocks owes much to:

• moderate signs of economic recovery in the USA
• often attractive dividend yields
• a sense that interests are so low that the potential risk/return characteristics of equities appear attractive

Yet the fundamentals of the economy have scarcely improved, and the stock market rally looks cyclical rather than sustainable, leaving fixed-income demand solid.

This period of expensive corporate bonds may last weeks, but probably not months. Our recommendation is to see the current period as an opportunity to clean up portfolios, ridding them of bonds which look especially over-priced.

Mortgage-backed securities ride again! The generic name may have moved to “bundled mortgage products”, which, according to the FT, banks are buying up enthusiastically. The specific name of “CDO” seems to have yielded to “CMO” (Collateralised Mortgage Obligations), as being more specific and carrying less historical baggage. There is however a big difference with the CDOs of 2007/08: instead of sub-prime mortgages, the newer versions are based on government-backed mortgages.

Merkel is still playing her cards close to her chest. She now says that solving the structural problems of Europe (of which we mentioned three last week: Spanish labour laws, Greek tax evasion and French anti-entrepreneurship) will take many years. Does that mean that her “fiscal union” has to wait till these changes are complete? In the meantime the Greeks are taking negotiations on the next bail-out right to the brink, but the market clearly believes that an agreement will be forthcoming, albeit just in time.

The result is that a return to normality for the world economy will indeed take many years:

• in the USA the authorities have scarcely begun to address current budget deficits, never mind the long-term overhang of “entitlements” (Social Security and Health Care)
• in Europe, solving structural problems will involve years of tensions as social entitlement changes are made
• globally, the shift in manufacturing to Asia has to be absorbed over years as the Chinese and other Asian populations are allowed a higher standard of living by authoritarian governments

The recent drop in shipping rates (Baltic Dry Index) by two thirds from an already-low level is discouraging news for international trade. It is certainly too soon to break out the champagne to celebrate economic recovery.

Macro Focus

USA: unemployment fell from 8.50% to 8.3%, with non-farm payrolls rising 243,000, the largest gain since April, and exceeding all forecasts. Manufacturing grew at the fastest pace in seven months in January. The ISM manufacturing index rose to 54.1 from 53.1 in December. Bernanke stated that the economy is showing signs of improvement although it remains vulnerable to shocks, he called on lawmakers to reduce the long-term budget deficit and to address the entitlements underfunding. He noted that the labour market is still far from healthy

UK: construction output slowed in January to the weakest in four months; as measured through a survey of purchasing managers, falling to 51.4 from 53.2. In contrast, manufacturing jumped to an eight-month high, unexpectedly returning to growth after a quarter of contraction. Services were also stronger than expected, the PMI for services from 54 in December to a 10-month high of 56. Bank of England policy maker Adam Posen said he’s “leaning” toward more stimulus next week and that there is a case to increase the QE target by a further £ 75 bln

Euro Zone: retail sales unexpectedly declined in December, led by Germany and France, dropping 0.40% following a similar decrease in November. Spanish unemployment registrations rose by the most in three years in January, the number of people signing on for jobless benefits increasing by 177,470 to 4.6 million. France and Spain issued new bonds at declining borrowing costs. France sold almost € 8 bln of six- eight- and 10-year debt at the top of its planned range. Spain sold €4.56 bln of bonds maturing in 2015, 2016 and 2017, just above its target

Germany: factory orders, adjusted for seasonal swings and inflation, rose more than expected in December, climbing 1.70% from November, when they had dropped 4.0%. Industrial output in November had also dropped by 2.9%, the most in three years

Switzerland: exports rebounded in December from a slump in the previous month. Foreign sales rose 6.10% from November, when they declined a revised 4.80%. SNB interim Chairman Thomas Jordan said policy makers are ready to buy “unlimited” foreign currencies if needed to protect their minimum rate on the CHF. Rhetoric in respect of maintaining the 1.20 level has been ratcheted up over the past few weeks

International Trade: the Baltic Dry Index, a measure of shipping freight costs, has fallen over the last six weeks from 1,900 to 700, but may be bottoming out