Bond Outlook March 7th

As we write, the market correction has paused. For reasons we explained last week (the US housing market obliging US households eventually to align income and spending, and carry-trade unwinding), a pause is not an end. It does however give investors (and commentators!) a chance to reflect without the pressures of an emergency situation.

Let us go back to these same two root causes of the correction and examine what the likely next steps will be in the chain of events:

• If US households are forced to match spending to income, spending must decline. Whether the decline goes all the way to a recession or just to anaemic growth is the unanswerable question. Ex-Fed Chairman Greenspan puts the probabilities at 30% for the former
• Further unwinding of the carry-trade will mean downward pressure on high-yielding currencies and bonds. Spreads on emerging market and low-credit corporate bonds are widening, and we see this process continuing for some weeks, before increased positions in these securities can again be recommended

Despite well-founded optimism that the world is better able to cope with a US downturn than in years past, it would be wishful thinking to suppose that there will be no negative effect.