Bond Outlook [by bridport & cie, June 18th 2008]
Three major questions this week are of key importance to fixed-income investors adjusting their strategy. We shall give our own answers and seek the conclusions to which they lead:
Question 1: is the negative impact of the credit crunch on the economy now almost over? No, far from it. Real losses from defaults have yet to be recognised, and the impact of a serious credit squeeze has scarcely begun. Be very careful of accepting at face value any announcements by those in authority to the effect that the worst is over.
Question 2: is inflation under control? No, and it is likely to get worse.
Question 3: are central banks serious in their intensions to fight inflation by raising interest rates? Of the three questions this is the most difficult to answer, especially when so many respected commentators are asking whether Bernanke and Trichet have taken leave of their senses in speaking of higher rates when the economy is in such trouble. We come down in favor of a most probably, yes. The only reason it is not a most certainly, yes is that the economy could yet nose dive, in which case inflation would have come back under control anyway. Yet even we are not that pessimistic!
If we are correct, then keeping short maturities and high quality remains appropriate. In addition the position of inflation-linked bonds in portfolios should be reinforced. We stress however that linkers are for long-term protection, not for short-term trading. In addition we would normally add floating rate notes to our recommendations, but they are issued mainly by banks, a sector about which we are very cautious.
Banks are now competing with emerging markets! As our readers well know, our traditional recommendation on the search for yield has been emerging markets, including for selected countries, sovereign bonds in domestic currency. Now, however, highly competitive yields, e.g. over 8%, are obtainable from bonds issued by the western financial sector. This reflects the dire straights of this sector, but if you believe that banks have a de facto safety net under them thanks to central banks, then the attraction of such yields is undeniable.
The credit crisis is still closely linked to US housing prices and to the low interest rates available in recent years. Likewise the huge increase in crude oil prices is also a result of low interest rates and the weak dollar. These two issues cannot however be the sole explanation for the oil price hike. Very obviously the world is running out of cheap oil, a point we made in this Weekly five years ago when we reviewed Jeremy Rifkins book The Hydrogen Economy. His analysis of how and when oil would enter shortage was accurate, although his technical solution of fillings vehicles with hydrogen has turned out to be less realistic.
We have just read an analysis published by Credit Agricoles CLSA U in Asia, in which the views of Lester Brown of the Earth Policy Institute, Washington DC, are propounded. We see Brown as prescient as Rifkin, but his call to the world extends beyond energy to land for crops and water to irrigate them. He advocates both wind farms and nuclear generation to provide energy and takes heart from a grass roots opposition to coal fired power plants in the USA in the light of coal being the worst offender in producing carbon dioxide. He calls for a focused research effort to reduce water usage in agriculture and to recycle water in towns. His data and forecast reinforce our contention that inflation is rising and here to stay. A simple one-off rise of 25 bps in the Fed rate in August cannot be the end of a long period of rate rises and belt tightening.
(?) EUR yield curve: the swap curve has inverted from one year onwards, with a marked rise at the short end: 90 bps in two years. Nevertheless, apart from the rise out to one year, the ten year yield (5.05%) is scarcely above the three month (4.96%)
(?) USD yield curve: in contrast the USD swap curve has steepened rising sharply from the 2% Fed target overnight rate and adopting a "normal" shape throughout
() Banks: Under new pressure because of doubts on their ability to raise new equity capital. Lehman Brothers estimates its loss in the second quarter at USD 2.8 billion; bring the total write-offs to date to USD 17 billion. The Goldman Sachs plan to restructure SIVs by establishing market prices is welcome as a touch of transparency
(+) positive for bonds () negative for bonds (!) watch out (?) begs the question
Recommended average maturity for bonds.
Our recommendation to maintain short maturities remains firmly in place.
As of 23.04.08
As of 02.04.08
Dr. Roy Damary