Bond Outlook June 11th

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In the debate dual-mandate versus inflation-focus for central banks, the ECB approach of “control inflation and the rest will follow” seems ahead with even the Fed coming round.

Bond Outlook [by bridport & cie, June 11th 2008]

Last week we wrote that it was difficult to call the moment when a bubble begins to deflate, then promptly demonstrated just how difficult this call was by suggesting that the turning moment for the commodities bubble had arrived. Wrong! Oil turned right around and began climbing again. We are duly humbled and will be more hesitant about sticking our necks out again! Yet the principle remains that the current commodities bubble, even including oil, will eventually deflate.

Where we were quite right last week was on the assertion that Bernanke has finally admitted that a weak USD feeds inflation, implying an end to rate cuts and a decent pause in the dollar’s decline. Now a whole international debate has broken out about dual mandates à la Fed (inflation with no specific target plus maintaining employment growth) versus focused mandates à la ECB (inflation with a specific target). There has been a huge shift in professional opinion about the ECB over the last year, from “if only the ECB would loosen the money supply to encourage the economy like the Fed” to “hasn’t the ECB done well to maintain interest rates in an attempt to control inflation, and the economy has not suffered much after all”. Even the BoE is seen as in the same camp as the ECB and Mervyn King seems to have restored his own credibility and the Bank’s autonomy.

Now it appears that Bernanke, expressing for the first time a Fed opinion on the strength of the USD (that was always left to the Treasury, where anything said by Paulson has achieved the unenviable status of being dismissed as pure propaganda), is leaning towards a stronger inflation-fighting approach. The Fed’s problem is that the rules have changed. Inflation is now an external affair and there is no wage inflation to bring under control. There are plenty of factors slowing down the economy anyway (rising energy and food prices, falling house prices, shortage of credit), so increasing borrowing costs can but slow it down more. We may even claim that Bernanke now reflects the views that we have proposed here for years, viz. that belt tightening by US households is a disagreeable but necessary step for the US economy to establish a healthy base from which to move forward. Long-term readers may remember our sense of being let down in our faith that Bernanke knew well things had to change but then, faced with the credit crisis, simply became “Greenscam Mark II”. If he has now confessed the error of his ways, so much the better for the US and world economy in the long run. Not surprisingly US households differ and are still seeking credit to maintain spending (see Focus).

The swap curve clearly reflects the bond markets’ assumption of rising interest rates. For us it is difficult to make new recommendations; all that we have said in recent months about inflation being present and climbing but manipulated in official figures, about avoiding financials, on shortening maturities and in favour of countries like Brazil and Russia in local currencies, has proven appropriate. We have also recommended an expanded role for inflation-linked bonds, but suspect that much of the expected inflation is already priced in.

From the beginning of this credit crisis we have stressed that for most fixed-income investors, capital preservation should override the search for yield (and recommended the Real, Rouble and the like for the latter). It is understandable that, given low bond yields, poor stock market performance and housing deflation, investors have sought to participate in the commodities bubble --- despite the risk of it deflating. Let it not be forgotten that the credit crisis is only entering phase 2 (credit squeeze) and that issues like monoline insurers, credit default swaps, repatriation to bank balance sheets of SIVs, tighter regulation of banks and of rating agencies may be less featured in headlines, but are far, far from being resolved.

Focus

(–) Europe: an increase in the repo rate has been flagged in the euro zone

(!) Switzerland: unemployment is at its lowest for six years. It held at 2.6% in March and April, but fell in May to 2.4%. A forthcoming increase in the bank rate is already built into bond prices

(!) China: the Shanghai stock market fell by more than 8% on monetary tightening of 1%

(+) Canada: Bank of Canada was expected to lower its target rate by 0.25% to 2.75%, but backed off

(+) Germany: the trade surplus approached EUR 70 billion over January to April, an increase of 7.7% over 2007

(?) France: Natixis is planning an issue of EUR 1 billion in convertible bonds to help repair its balance sheet after sub-prime losses

(?) USA: consumer credit expanded 4.2% in April after an increase of 6.2% in March. This was higher than expected

(+) 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.

Currency:

USD

GBP

EUR

CHF

As of 23.04.08

2011

2010

2011

2011

As of 02.04.08

2015

2010

2015

2011

Dr. Roy Damary