Bond Outlook [by bridport & cie, March 5th 2008]
My thoughts were of trouble, and mine were steady, so I was ready when trouble came. (Housman)
The trouble which markets have been going through for many months is steadily growing. The recommendation that we made weeks ago should have helped readers be steady: government bonds, long maturities, with a firm place for inflation-linked bonds, and a modest place for sovereign bonds in the domestic currencies of selected emerging markets, especially Brazil and Russia. To these we can safely add the AAA supra-nationals. Obviously many investors are indeed focusing on government bonds and, for the first time in the history of our company at least, a certain lack of availability of German government bonds among market makers has appeared. In contrast, spreads on Greek and Italian government bonds are widening in the light of economic and political weakness. The old convergence trade is truly reversing! In the current environment fixed-income investors are risk-averse to an extreme.
A month ago we opined that the US authorities could not possibly be contemplating letting the monoline insurers be downgraded, as the impact would be disastrous. Warren Buffett proposed taking over the municipal bond part of the business, unsurprisingly not taken up by the monolines, as that would have left them with vulnerable corporate debt. However, he sowed the seed of splitting the monolines into two with the AAA rating maintained only for the municipals. Now even that idea has stalled, and has been formally rejected by Ambac. This may be the final nail in the coffin of the auction-rated municipal bond markets, which have seized up with the fading of salvation for municipal bonds...
Disarray about how to address the monoline problem is matched by the US authorities approach to dealing with foreclosures. On the one hand Henry Paulson calls upon householders with negative equity to act responsibly by continuing repayments and not walking away. On the other, Ben Bernanke is calling upon banks to forgive the debt of troubled mortgage borrowers. These appeals might not be completely contradictory, but it is certainly difficult to reconcile them. For once we would applaud Paulson rather than the Bernanke, who seems now to have completed his transformation into Greenscam Mark II with the philosophy dont worry if youve made a bad investment or borrowing move, well bail you out! Set the US authorities approach to housing against their dealing with monolines, and ask yourself whether they really have any idea of what they are doing. Long gone are our hopes expressed on this Weekly that Bernanke knew his countrymen had to tighten their belts and would quietly let that happen with a view to a better balance in the world economy.
HSBC always impressed us by being first to admit to sub-prime losses over a year ago. Now they are announcing losses in the broader consumer loan market in the US where they are a major player: EUR 17 billion bad loans in 2007, and this year is not looking any better. Add to all the above, leveraged hedge funds failing, collateralised loan obligations selling well below par, the sub-prime losses at Credit Agricole being as bad as expected, inflation everywhere but not being admitted by governments, and the emergence in problems of VIE (see last weeks text), and it is very understandable that fixed-income investors are fleeing to top quality. Will the stock markets be last to turn out the lights?
Despite the knock-on effects of sub-prime throughout Europe, there is room for moderate (actually very moderate) hope that Europe will not be dragged down completely by a US recession. Whither European interest rates in the next few months is very difficult to forecast. For the moment the inflation-fighting credentials of the ECB and the SNB remain solid, and even those of the BoE are not weak. Yet is difficult to imagine European rates not being timidly reduced as US rates are cut still further. Moreover, excessively strong currencies can be an economic burden. The safe-haven status of the CHF (which we admit to having thought long gone) has returned with a vengeance.
() USA: Bernanke says some failures of small banks likely but denies possibility of stagflation
(!) USA: the index of the Institute of Supply Management has dropped below the neutral threshold of 50
() France: the respected magazine 60mm de consommateurs has estimated milk and cereals to have jumped by between 5% and 48% since October. The Government argues that it was only by 27%!
(+) Canada : decrease in the overnight rate from 4% to 3½%
() Australia : increase in the overnight rate from 7% to 7¼%
(+) positive for bonds () negative for bonds (!) watch out (?) begs a question
Recommended average maturity for bonds.
Stay long maturities in USD and EUR. Quite short in CHF and GBP.
As of 09.01.08
As of 22.08.07
Dr. Roy Damary