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Bond Outlook October 8th

The UK Government injecting equity capital (preference shares) into banks before they need to be nationalized outright in panic may signal that exit from the storm is in sight.

Bond Outlook [by bridport & cie, October 8th 2008]

It is our destiny always to be out of step with general market opinion. For years financial markets believed that the unsustainable could go on for ever and we cried that that was impossible; now markets have lost all confidence, while our view is that markets will return to normality, but probably not until after the year end. By “normality” in this case we mean ease of trading and normal bid/ask spreads. Trading liquidity will improve across the board, although assets will be valued at much more modest levels as the world economy goes through a recession. (Last week we listed the main changes we expect in financial markets next year.)

Full economic normality, by which we mean interest rates being a percent or two above inflation, economies growing and house prices restored to modest growth, is years away. Let no one forget the underlying causes of the crisis, the housing bubble and the Greenscam practice of throwing cheap money at every natural adjustment mechanism that arose on his watch. Add to these the excesses of Wall St with its structured products and off-balance sheet vehicles, and the fall now underway is even greater than it otherwise would have been.

The reason for our (entirely relative) optimism is that governments have finally focused on the main problem in banking: capital adequacy. Liquidity injections are necessary wound dressing, but real healing will come with capital injections. In that regard, the UK government’s promise to invest in banks via preference shares should set an example that other countries will be under pressure to follow. Nationalisation in extremis of failing financial institutions on both sides of the Atlantic may be better than bankruptcy, but is scarcely a recipe for reviving market economies in which bank assets are many times GDP or existing government debt. In contrast, capital injections via preference shares have the huge advantage of allowing banks to continue as independent entities while both imposing reasonable constraints on their risk taking, as well as offering the UK government (and therefore the taxpayer) a serious possibility of a good return on investment when the dust settles.

We would even hope (please excuse our “wild” optimism) that the imminent capital injection in the UK will avoid the slightly ridiculous sight of a Central Bank (the Fed) lending direct to corporations via commercial paper.

The UK move seems to be the best yet in terms of government/central bank approach to the crisis. In the USA, the actions have been either effectively outright nationalisation or buying toxic assets. Time will tell whether the UK intervention works as well as may be hoped. Paulson overlooked the capital injection option, and we wonder whether he regrets not calling on it. Or would he have, had Wall Street bosses not advised against it for their own ends?

In the meantime, other “wound-dressing” moves include more liquidity from central banks and the co-ordinated lowering of interest rates as just announced.

Of the main financial markets – equities, bonds, money markets and forex – we observe that markets with no or only short-term counterparty exposure, notably, equities and forex, are trading freely, but money markets have largely seized up, apart from the overnight market, while bond markets are functioning, but with wide bid/ask spreads. We can report that we are able to complete the great majority of trades for our clients – it just takes much more time and effort to achieve execution.

Fixed-income investors might ask themselves whether they really believe the entire financial system will grind to a halt, with all that implies for financial losses and an economic depression. We do not so believe; in terms of time horizon, we see the dust settling by early 2009, provided other governments follow the UK’s example. If not, rolling over bonds in the next few months will be very difficult. If our meteorological analogy is appropriate, financial markets entered the storm in spring this year, were in the eye in summer and are again in the storm, but with the exit in view. For the brave, and even for the nervous for a part of their portfolios, there are some very attractive yields available in the corporate sector, including (dare we say it?) among financials. In the run up to this crisis we warned readers to avoid financials like the plague, but the time to move back into them is close.

We remain intrigued as the where the money will go when it returns from the safe havens of government Treasury bills. For the moment we still see it going into long-term quality bonds.


(–) USA: a major recession now expected: no growth from mid-2008 to mid 2009 with a decline in GDP of 2% in the current quarter, then -1% in the next, followed by two quarters of “zero” growth. Unemployment likely to approach 8% by the end of the year. A further cut in the Fed rate of 50 bps expected along with an easing of fiscal policy

(!) Bank rates: The RBA has lowered it interest rate by 1% to 6%, and US, UK and Euro zone by 50 bps

(+) Iceland: Russia has made a loan of EUR 4 billion (to a member of NATO!)

(?) Denmark: Danmarks Nationalbank has raised its key rate from 4.6% to 5% (the discount rate from 4.25% to 4.5%)

(+) positive for bonds (–) negative for bonds (!) watch out (?) begs the question

Recommended average maturity for bonds.

Following recent gains on short-term Sterling, we recommend profit taking and lengthening, only in government and supra bonds.






As of 8.10.08





As of 16.07.08





Dr. Roy Damary

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