Bond Outlook [by bridport & cie, May 28th 2008]
Often have we written of living through a historic change in the worlds economy. Two events this week epitomize that shifts two main features:
Fortunately it is not our responsibility to forecast stock market behaviour, but we cannot but wonder how a drop back in oil to USD 129 can provoke a stock market rally.
The two main events look coincidental. They are in reality closely intertwined. The Greenspan policy of using cheap money to avoid the impact of bursting bubbles itself fundamentally irresponsible because the proper economic healing/adjustment has been disallowed has led to ever greater irresponsibility, from deficit Federal finance to excessive household debt to a denial of risk. The cheap money policy has then led to a spending boom in the USA and the West in general on which Chinese production has flourished, leading the Chinese to buy T-Bonds to keep the USD artificially strong and interest rates down. However, whilst the USD fall has been slowed, its weakness has caused an increase in most commodity prices, which together with the emergence of middle class in emerging countries, together with poor policy decisions in developed countries (e.g. ethanol subsidies), has caused oil and food demand to sky-rocket (from both a consumer and asset allocation viewpoint).
We would suppose that the fall will be all the greater as US authorities continue to block the disagreeable but healthful effects of market forces like higher oil prices. It is hard to find examples of greater economic nonsense than proposing to remove the gasoline duty to ease the pressure of more expensive oil. That would only allow still higher prices and profits for oil producing countries and petroleum companies while doing nothing to reduce demand to match supply at a lower price level. This crunch on oil supply was bound to come; it has but come sooner that we thought. At least the move to alternative energies and lower consumption is now in earnest.
Readers are well aware that we see trouble brewing in Credit Default Swaps. In addition (and we thank Asianomics) another old problem in the form of monoline insurers looks like reappearing. With a little help from their friends in high places, monolines managed to avoid being downgraded as a result of their misadventure into CDOs. But linkage and knock-on effects like that between oil and cheap money show up also for monolines. Most of the municipal bonds they insure are for public works and are backed by property taxes. What must be happening to property taxes in an era of foreclosures and falling house prices?
Ever since the first signs of the current crisis appeared, the authorities have played the game of reassuring the public that the crisis is limited in scope (just sub-prime or just housing or just investment banks. Our conclusion: do not believe a word they say. This crisis has further to go, will spread into more aspects of the economy and will affect more countries than even we could ever have imagined.
Despite the signs of improved bond market liquidity ever since the Bear Stearns bail out, we cannot yet say that normal service has been resumed. The market makers staff still manage to have stepped out of the office for many attempts to trade long-dated financials, and are seeking ridiculous bid/offer spreads.
Events are supporting the outlook we have been painting for several months:
() Yields: less talk now of the sub-prime crisis, leading to supposition that the next Fed move will be up before the year end. Meanwhile yield curves are flattening by a rising short end
() Inflation: the risk is at least being recognised and tightening in Europe seems likely
() Switzerland: rumours around the SNB point to a possible rate rise on June 19
(+) positive for bonds () negative for bonds (!) watch out (?) begs the question
Recommended average maturity for bonds.
Short across the board.
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|Dr. Roy Damary|