Bond Outlook May 21st

Rarely have so many disruptions and disquieting trends hit the world economy simultaneously. Accordingly, it is difficult to understand the relative calm of financial markets:

• The credit crisis is entering its second phase with the liquidity problems more or less solved but the full impact of the credit squeeze still to come
• The world is rapidly running out of cheap oil, while new, expensive oil and alternatives are not yet on stream
• The demand for oil and food from the Asian developing economies is growing hugely
• Switching agriculture to ethanol production has exacerbated the food shortage
• The dangers of a Mideast flare up are increasing
• The data on inflation is misleading
• The US economy is in recession

We do not intend this week to go through these various assertions, but rather to use them as a backdrop to a particular problem which we see as a major component of the second phase of the credit crisis: credit default swaps (CDSs). Early warning signs arose in April from Swiss Re, reinforced by AIG’s much greater write-downs last week on CDSs (USD 9.1