Bond Outlook January 16th

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Systems failure, first cited by us last July, is now apparent and will demand months or years to repair. Contagion from the USA is looking more serious than we thought.

Bond Outlook [by bridport & cie, January 16th 2008]

Exceptionally, let us start this Weekly with a quote from an old one:

“ Moody’s says that the credit rout gives “serious reasons to worry but does not pose a systemic threat”. The Fed’s W. Poole assures that “the impact of the sub-prime problems will be contained to the real estate market and will not hurt the economy much”........We disagree.”

We wrote that on July 25th, last year. Six months later these “authorities” would, we presume, prefer not be reminded of their misplaced re-assurance. There is so much going wrong with the US economy, with its repercussions elsewhere, that for us to list once again all the problems is superfluous; every reader has read of the bank bail-outs, the likelihood of credit default swaps being supported by inadequate capital as corporate defaults rise, and the decline in US consumer spending. Since the start of the year the debate about “slowdown vs. recession” has moved distinctly in favour of the latter. When Bernanke took over from Greenspan, we called his inheritance “a poisoned chalice”, such it has certainly proven to be!

Likewise the shift in economic power from a unipolar to a tri or multi-polar world is accelerating: Asian, Mid-Eastern and Russian money is coming to the rescue both in terms of equity injections and the hope that demand in these areas will maintain overall expansion of the world’s economy and prevent Europe following the USA into recession. To deal with an overvalued EUR, European companies are finding opportunities to make direct investments in production facilities in countries with highly-skilled and willing workforces, and weak currencies, for example, the USA (witness the example of Airbus)!

The answer to our “Christmas break” question about liquidity injections addressing problems of solvency can now receive a more refined answer. In terms of closing the spread between Libor and government bills, it was successful, although the central banks’ intervention of last month may have reached its limit. In terms of encouraging banks to fulfil their responsibilities as market makers of issues they happily sponsored and lead-managed, so that the bond market functions smoothly, the central bank intervention is a total failure. Traders are willing enough to sell, but very reluctant to increase the size of their books. Capital is clearly scarce and needed in other areas with “more urgent” problems. The small improvement of bond market liquidity we reported in December has disappeared. Screen prices do not hold, bid/offer spreads are wide, and, for sell orders, many traders seem to have caught a mysterious and violent bug, causing them long stays in the washrooms! This situation makes our work harder, but more valuable, and is continuing to enhance the openness of our discussion with our clients, and their appreciation.

While conventional wisdom is to be very defensive and in short bond maturities, we still see two opportunities, already recommended in this Weekly, but still valid:

  • long average maturities in EUR and USD still give additional spread, and yields at, for example, 10 years, will not rise significantly yet (there will come a time when shortening becomes urgent)
  • our long-standing recommendation on sovereign bonds in local currency of selected emerging markets has proven most successful and still stands

Until this week we saw the ECB holding rates firm even while it is almost certain that the Fed and BoE reduce them imminently. Now, with the Fed promising lower rates, and the contagion of an economic slowdown becoming more apparent, the idea of the ECB lowering its repo rate is becoming more credible. However, that is a reflection of what people are saying Trichet should do, which is not the same as Trichet saying it himself!

But to return to our opening comment about systems failure: Western economies are now indeed going through such a failure. The system will be repaired, but that will take months or years rather than weeks. So be prepared for a long and difficult period!

Focus

(+) USA: expectations of a cut of 50 or even 75 bps by the Fed are positive for the bond market but are no longer “automatically” pushing up equity prices

(+) Russia: having lagged other emerging markets, Russia’s financial markets seem destined to perform well in 2008

(–) France: a record trade deficit in 2007 (EUR 38 billion). The usual problems are cited: crude imports, a strong EUR and poor competitiveness of French exporters

(!) Lawsuits: “Advisen”, an adviser to the insurance industry, has identified over 20 banks and mortgage lenders now subject to sub-prime related lawsuits. They expect them to lead to insurance claims from the defendants.

(+) positive for bonds (–) negative for bonds (!) watch out (?) begs a question

Recommended average maturity for bonds.

Long maturities in USD and EUR, but ready to shorten. Quite short in CHF and GBP.

Currency:

USD

GBP

EUR

CHF

As of 09.01.08

2018

2010

2018

2011

As of 22.08.07

2014

2010

2014

2011

Dr. Roy Damary