Bond Outlook April 23rd

The damage done to liquidity in the financial services industry by the credit crisis is slowly on the mend (see “Focus” below), but within an environment of inflation and a US recession. If that description of the financial world is accepted, what does it mean for fixed-income investments? We see three dimensions to a likely answer:

• Continue the shortening process we began three weeks ago
• Venture very cautiously and selectively into the area where mending is taking place, i.e., into the finance sector
• Enhance the role of inflation-linked bonds

The BoE has belatedly joined the Fed and ECB in setting up facilities to exchange mortgage-backed securities for government bonds, but nevertheless at a price to pay for past errors. All the central banks are following the example of the ECB in recognising that, with the liquidity crisis partly out of the way, attention needs to be directed towards bringing inflation back down, even if they are still running scared of a slow down. Their focus must be on real inflation, not the meaningless “core” rate that excludes energy and food.