Bond Outlook January 9th

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For perhaps the first time in a hundred years, the world economy may be able to expand despite a slowdown, or even a recession, in the USA.

Bond Outlook [by bridport & cie, January 9th 2008]

What is our own answer to our end-of-year question on whether a massive loosening of liquidity can solve a solvency problem? Basically that the operation has worked in the sense that Libor and government bond yields have now moved much closer to each other. The action of the central banks was therefore a wise and necessary action. However, whilst liquidity has improved in the inter-bank market, it would be a big leap to say that the economy is out of the woods. On that issue a distinction has to be made between the USA (and countries such as the United Kingdom that have a significant exposure to a drop in house prices), on which we remain pessimistic, and the rest of the world, about which we remain quite sanguine. Even a week ago it appeared that in the USA the equity markets were bullish and the bond markets bearish, but currently the two markets are taking the view that there is more bad news to come:

  • The underlying causes of all the problems (falling house prices and excessive household spending) remain absolutely unresolved
  • More bank sub-prime losses are certain to be announced
  • Many buyers of CDOs, both in the USA and abroad, are now suing banks on mis-selling
  • Corporate bond defaults are set to quadruple (Moody’s)
  • Credit default swaps will cost the holders up to USD 250 billion (Pimco)
  • The monolines remain vulnerable to downgrading, which will impact the bonds they guaranty
  • SIVs without a link to banks are being massively downgraded (e.g. “Victoria” of Ceres Partners)
  • Merrill Lynch stated this week that the USA to be already in recession, although this view is controversial

As Stephen Roach of MSI points out in one of his (now rare) articles, the underlying causes can be addressed only by Americans returning to income-supported savings, and that will only happen when the asset bubbles, which took the place of savings, deflate. This is a painful but essential process, which has actually begun, but can continue only if the Fed and the Administration resist the temptation to inject so much liquidity and fiscal stimulus that the whole cycle begins again, merely putting off the day of reckoning once more (although in an election year, the administration might just do it).

Despite the relentlessly bad news on the US economy, there is room for more optimism on the rest of the world. For what is probably the first time in a hundred years, the world economy as a whole seems set to continue expanding even though the USA is contracting. Of course, there are weak spots -- the UK is dangerously close to following the same path as the USA, and Spain has a deflating property bubble -- but overall, Europe, led by Germany, but also benefiting from the membership of low-cost Eastern European countries, is surviving the weak dollar remarkably well. The huge infrastructure investments of Asia, the Gulf States and Russia are giving Europeans excellent export opportunities, and the growing consumer demand in these regions is also cause for optimism.

Inflation is threatening everywhere, but its pressure is lower where currencies are strong. In addition, the central banks of Europe are more committed to restraining inflation and therefore less inclined to reduce overnight rates than the Fed. Our own appreciation of likely Fed policy is that the fight against inflation will be temporarily suspended in favour of softening the downturn. That means further lowering of the overnight rate, while the long end of the yield curve remains much where it is, but only for a few months. The Chairman of the Philadelphia Fed is concerned that “developments on the inflation front will make the Fed's policy decisions more difficult in 2008”, he also stated whilst temporary measures may be necessary to ease financial market turmoil, the Fed’s main target should be ensuring price stability and not growth.

For institutional investors this may provide a trading opportunity of a few months until the Fed reasserts its concern about inflation and the entire yield curve begins to climb. This leads us to the proposal to lengthen, both in USD as a trade (ready at all times to shorten), and also in EUR where we see a much more stable yield curve and where a long maturity is an investment position. For the CHF and GBP the spread available makes such lengthening less than worthwhile, and we would not be surprised to see the GBP yield curve move from inverted to humped over the course of the next few months at around the 5 year mark as the Bank of England starts to lower its benchmark rates. Some forecasts predict the official rate as low as 4% by the end of 2008.

Focus

(+) Central banks: the joint operation in December attracted 240 banks and had the sought-for effect. The ECB is now withdrawing the extra liquidity

(+) Euro zone: unemployment at 6.9% at its lowest, although the confidence index fell back slightly in December

(!) Spain : the problems of Colonial are creating fears of a sharp fall in national economic performance which has been so dependent on construction. This will increase the dilemma facing the ECB

(?) USA : disappointing data on job creation : 18, 000 vs. 70, 000 expected, hence more pressure on consumer spending and increased risk of recession

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

Recommended average maturity for bonds.

Lengthen in USD as a trading opportunity and in EUR for investment. Little change in CHF and none in GBP.

Currency:

USD

GBP

EUR

CHF

As of 09.01.08

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2011

As of 22.08.07

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2011

Dr. Roy Damary