Bond Outlook March 12th


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This crisis is not just about illiquidity but also about insolvency and the fear that borrowers, including banks themselves, will not repay. The Fed “boost” misses the point.

Bond Outlook [by bridport & cie, March 12th 2008]

The USD 200 billion+ “boost” by the Fed is very clever (maybe too clever by half), as it addresses the illiquidity problem of mortgage-backed securities by allowing the use of AAA bonds as collateral for Treasuries. This gives the banks the means to borrow from each other and meet the needs of their clients. Equity investors clearly “bought” this line on Tuesday, although there is something inevitable about any move by the Fed to “inject money” causing a short-term stock-market rebound, exaggerated more than ever this time by unwinding of short positions.

The Fed is addressing the liquidity problem, but is the credit crisis only about liquidity? We (and many others) fear not. Solvency is also very much at stake, i.e. the balance sheets of many financial entities are vulnerable because of the write-down of assets. On the one hand banks cannot lend because they do not have the cash or the capital adequacy (and the Fed is addressing this issue), but on the other they are reluctant to lend to anyone if the risk of bankruptcy is in the air.

A reminder:

The general cause of US problems is the deficit and debt-based economy

The trigger for the current crisis is the fall in house prices

The credit crisis reflects excessive leverage – always highly negative with declining asset prices

There is no quick fix to these issues. Only time, belt tightening, working through price misalignments, and economic rebalancing can return the US economy to health. The authorities have neither the time nor the will in an election year. Price realignments require time: years of time, not just months. In a sense the authorities are helping this process as they have opened the door to inflation. Food and energy inflation will wash through to wages (but to a reduced extent, thus bringing about the belt-tightening we see as unavoidable), while house prices fall but eventually stabilise at a lower level. The US authorities have no credible or coherent plan to solve this economic crisis of their own making, but market forces will eventually do the job for them and despite them.

Data on housing in the USA highlight the problem. There are some 46 million mortgages in the USA. As of today 2% are in foreclosure and 6% delinquent. House prices have at least 20% further to fall. This will raise the number of households with negative equity to as high as 20 million. Of these, anything from 20% (Goldman Sachs’ estimate) to 50% (Professor Roubini’s) are likely to default. Moreover, for the Adjustable Rate Mortgages (ARM’s) at the heart of the sub-prime crisis, it is likely that further bad news is to come. The data on payment defaults are released roughly three months after the event, and the peak of mortgages due to be reset is in March this year. This implies that if current trends continue, the worst news on the mortgage crisis will not be released until about June. Congress may now make it harder to foreclose, but they will not be able to stem the “walk away” phenomenon.

Even though the authorities contradict each other (“don’t walk away” from Paulson for negative equity holders vs. “don’t worry, we’ll bail you out” from Bernanke), there is a degree of collaboration, or should it be called “conspiracy”. The two larger rating agencies are taking a very long time to get round to key categories of bond issuers, although Fitch is apparently breaking ranks. Credit markets know or strongly suspect that many investment grade bonds are due for downgrading, as reflected by the inadequate market making of even AAA corporates. We have to go as far as saying that bond markets are in great disorder. Apart from government bonds, no “screen price” corresponds to reality. We warn our clients that patience and understanding are required as we seek the best price case by case.

Inflation is more than beckoning; it is here. Governments are trying to fool the people with their “core inflation” measures which exclude energy and food. Wholesale prices in the UK rose in February at an annual rate of 5.7%. Other countries cannot be far behind. The ECB is valiantly trying to stem the tide, and the encouraging news from France and Germany (see “Focus”) will help it stay its hand, but the state of the economy will eventually break its will, probably by summer.


(+) US employment: declining even though unemployment slightly down as job-seekers give up

(!) Banks: Lehman reducing jobs by 5%. Banks are going alone to find individual deals with debtors

(–) US Trade: deficit up to USD 58.2 billion as the 1.6% increase in exports was more than offset by a record USD 206.4 billion imports

(–) E: spreads are moving above 200 bps in the light of the financial activities of this conglomerate focusing on lending, especially household credit

(+) France: unemployment at its lowest in 24 years, 7.8%

(–) China: inflation at 8.7at per year in February is highest in 11 years, while the trade surplus has declined to USD 8.56 billion, a third of the level 12 months ago

(+) Germany: trade surplus in January at record EUR 16.1 billion

(+) 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