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Bond Outlook November 5th

President-elect Obama has an intimidating task to repair the damage of the outgoing Administration, but they have more or less fixed the capital markets ready to face a long downturn.

Bond Outlook [by bridport & cie, November 5th 2008]

When Bernanke took over from Greenscam we opined that he was inheriting a poisoned chalice. President-elect Obama is being passed a poisoned pitcher! To quote a leading historian of presidencies: ”the new President will not be able to clean up the mess left behind by Bush”. We hope nevertheless that he will be so able, even if it takes some years. Let us also give a little credit to the outgoing Administration for clearing up the capital markets crisis – admittedly of their own making, and only because of the Swedish model and Gordon Brown showing them the way!

For a good month we have been stressing that the huge and unnecessary “side show” of the capital markets crisis was being resolved. We have also been stressing the buying opportunities in selective corporate bonds, including financials. The bond market is steadily moving to this view. Many government bonds, recently offering negative spreads to the swap yield curve, are now moving into positive spread territory. In contrast, the spreads on good quality corporate bonds are declining, although there are many excellent opportunities available, especially in short paper (and we report that despite our current preference for long maturities). The flight to extreme quality is over in favour of a preference for good quality.

Provided the ten-week transition period in the USA brings no more huge capital market shocks, the new Administration will be able to focus on the real problem of a recession. Recession cannot be avoided, but it can be managed. It is unavoidable because the “mewing” (mortgage equity withdrawal) has stopped. The apparent annual growth in US GDP in recent years owed typically around 3 percentage points to households increasing their mortgages and spending the funds borrowed. This route to spending more than earnings has been closing since early this year. Yet consumer spending has held up until very recently. How? By use of credit cards. Credit card loans have ballooned (some USD 60 billion in the last three months), even though retail spending is declining. The obvious conclusion is not that spending with the cards is growing (except apparently at McDonalds!), but that repayments are dropping fast. When the high interest rates on credit card debt are considered, a lot of households will be pushed into delinquency and losses will fall back on the credit card lenders and any asset-backed securities based on card debt

It is not only the USA taking this path: latest data from the UK show the same trend. Credit card debt now stands at a staggering £237.6bn, and rose by £300m between August and September alone. The point we would make is that repairs to the financial markets cannot alone solve the underlying economic problem. That will require not only several years for households to repair their “balance sheets” but also, probably, much Keynesian government spending to keep the economy turning. Government spending = deficit budgets = more borrowing = higher interest rates (but not yet!).

Let us return to our relative optimism over the repairs to the capital market crisis (only relative for we suspect the CDS story is not quite over (see Focus, Ambac). Many of the distortions of recent years are disappearing fast: certain types of hedge fund, massive proprietary trading by banks (with, in effect, internal hedge funds), securitisation with no relationship between lender and borrower, off-balance sheet vehicles, bonus systems which encourage excessive risk taking. Thus a more transparent, “kinder” capital market is emerging, which will serve the real economy well as the world works its way through this long downturn.

The bond market can take a lesson from the stock market; bond picking has already become a key component of fixed income portfolios.


(+) Australia: lowering of interest rate to 5.25 %

(–) Spain: unemployment at its highest in 12 years at 11.3% in October

(+) United Kingdom: « Lloyds Banking Group » will emerge from the merger with HBOS

(?) Germany: Commerzbank following the example of its public rival, Bayern LB, in accepting government aid

(!) Private equity: warning by Carlyle Group and others that debt payments and profit generation will be delayed

(+) Switzerland: in December a decision will be made about raising the guaranty on bank deposits from CHF 30,000 to a likely CHF 100,000.

(+) ECB: markets expect a 50 bps cut in the repo rate (to 3¼%)

(–) CFS: Ambac has announced mark to market losses in Q3 of USD 2.43 billion

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

Recommended average maturity for bonds.

No change.






As of 8.10.08





As of 16.07.08





Dr. Roy Damary

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