Bond Outlook January 9th

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.