Bond Outlook July 25th

Moody’s says that the credit rout gives “serious reasons to worry but does not pose a systemic threat”. The Fed’s W. Poole assures that “the impact of the sub-prime problems will be contained to the real estate markets and will not hurt the economy much”.

We disagree. The financial system in the USA has failed and will need revamping, not least with regard to the operations of the rating agencies. The knock-on effects of the sub-prime debacle will have a profoundly negative impact on the economy in the coming months, because:

• as mortgage defaults accelerate (“Alt A hybrid adjustable-rate mortgages” are defaulting as fast as sub-prime), the decline in house building and prices will dampen household ardour and ability to spend beyond their means
• the tightening of credit both in spreads and terms and conditions (end of “covenant-lite” and the like) is far from limited to CDOs, but is extending to the entire apparatus of cheap and readily-available borrowing for leveraged buy-outs

The second point should eventually bring about a stock-market correction, although the ability of equity markets to charge on regardless after corrections of 1 or even 2% in a given day never ceases to amaze us.