Bond Outlook January 18th


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2006 is looking good and less dependent on the USA. However, the shift of the world's economy from unipolar to tripolar has serious implications for the cost of money.

Bond Outlook [by bridport & cie, January 18th 2006]

Even while the doubts about the sustainability of the US economic structure are growing, the overall outlook for the world's economy looks favourable. The world has moved marginally away from US-centricity but remains very vulnerable to belt-tightening by US consumers. It is as if everyone realises that the Americans have to cut back on their spending, but would like them to do so rather gently. That, presumably, is the view of the Chinese, responsible for one of the two economic driving forces we identified last week (support for the USD). The other driving force is the US housing bubble and its associated consumer over-spending, where the best hope is that Bernanke will be able to deflate the bubble rather than burst it.

Among the beneficiaries of a growing world economy is Switzerland. The Credit Suisse view is positive, thanks to the improvement in its neighbours' economies and its exports outside Europe. Modest interest rate rises may be expected for 2006 (2 x 0.25% are mooted), which may mean that returns on CHF bonds remain low, at least for a few months. This may imply wisdom in keeping short maturities in CHF. CS are recommending no more than 3 years. We are inclined to hedge our bets by bar-belling, and have now put this as our recommendation.

In historical terms, the world is still scarcely past the beginning of the shift we first wrote about two years ago from a unipolar world (USA) to a tripolar (USA, Europe, Asia). The second pillar of the new world structure, Europe, has been the subject of much criticism here and elsewhere because of the anti-business (or at least anti-entrepreneurship) policies of France and Germany. Yet Germany is reforming, and the contribution of the new Member States, with youthful populations and so much ground to make up, can easily be under-estimated. German companies have not been slow to take advantage of having competitive labour markets right on their doorstep. There is a touch of the hare and the tortoise about the USA and Europe, epitomised, as it happens, by Airbus revealing that in December it did, after all, take more orders in 2005 than Boeing in numbers of aircraft. Above all, Europe has not become vulnerable to dependency of foreigners' goodwill towards its currency.

Asia, in economics terms, is no longer "just" Japan, but is Japan + China + India. China's expanding industrial production (even with its negligible overall profitability) has been largely responsible for:

  • the massive relative price shift in the West from manufactured goods (cheaper) to services (dearer)
  • the slowing, even reversal in 2005, of dollar weakening
  • low long-term bond yields (and, indirectly) housing bubbles

All this will change - slowly, a point made this last week by leaders of the Bank of England. China remains the key. Two major moves may be expected in that country:

  • loss-making manufacture supported by bank loans has to stop, implying a general lifting of export prices (reinforced by any revaluation of the RMB), thus reducing or ending the downward price pressure on manufactured goods in the advanced economies
  • domestic consumption will expand, helping to close China's current account surplus and reducing the need to buy so many T-Bonds with surplus dollars

Both factors spell a reduction of the world's liquidity and the associated "savings glut". That spells inflation and higher interest rates.

But not yet. Let us therefore proceed into 2006 on the basis of only marginal rises in interest rates and continued flattening of yield curves. 2007 may be a very different story.

The threats to world peace and oil prices due to the Iran standoff could make all of this irrelevant.

Recommended average maturity for bonds in each currency

Introduce bar-belling for CHF, as the SNB and the ECB are both likely to raise rates in coming months.

As of 18.01.06 2011 2013 Floaters & 2016 Floaters & 2016
As of 04.01.06 2011 2013 Floaters & 2016 2013

Dr. Roy Damary