Bond Outlook May 19 2010

The fires in financial markets are still smouldering; nevertheless we remain hopeful that they will soon be fully doused as the EUR finds a new level and the EUR rescue package, along with the austerity plans of many Euro zone countries, bear fruit. Part of our reasoning for this apparent optimism is that there is simply no alternative, in the light of the determination of the architects of the single currency, to pulling through and maintaining the euro as the currency of the 16 member countries (plus any future participants).

The current period is one of fundamental change in the “West’s” economic model. Income disparities have widened to such an extent on both sides of the Atlantic that society itself is being shaken. In another era, revolution might have been conceivable, but now the governments have understood the public mood. Major banks being rescued by taxpayers’ money and then achieving huge profits and bonuses epitomise the malaise, and provide a first target for new regulations. Proprietary trading is under the greatest threat: although the Volcker plan to separate commercial banking from investment banking has less prominence, there is still every chance of it being enacted.

In general, however, it is speculation which is attracting the ire of politicians anxious to defuse popular resentment. The German Government has now banned naked shorting of many stocks and bonds, as well as related CDS operations (could this weaken demand for new Bund issuance from outside the Euro area?). For the moment they are acting alone, but we rather expect other European countries will shortly follow suit. The new UK Chancellor might have gone to Brussels ready to defend hedge funds, but backed off quite quickly when he sensed the mood. The CDS market is rapidly gaining a reputation as a tool for speculation and we therefore expect it to be targeted beyond the current German move.

Despite the successes of the “Tea Party” movement in the USA, with its call for lighter government, the dominant mood there is also in the direction of reining in financial market excesses; witness the investigations of banks and of market manipulation of municipal bond auctions. Trans-Atlantic co-operation in new regulations is likely, although the idea of the American taxpayer paying for other countries’ bail-outs is becoming anathema.

For Europe, the action of the German government can be interpreted is different ways, and may be controversial, as Germany has a lot of historical baggage to carry in any role of leadership in Europe. Yet the German action does at least (maybe we should say “at last”) imply a degree of decisiveness and, indeed, leadership. If the biggest and strongest economy does not lead, who will? As we have said in our recent Weeklies, the Euro Zone must have a degree of centralised fiscal management, i.e. of control over taxation and spending. Hoping that convergence will happen by itself, e.g. that Greeks and other southerners become as responsible as Germans, is simply unrealistic. Regrettably, a degree of heavy-handedness is necessary.

For our recommendations on bond maturities, the time has come to remove the distinction between government and corporate bonds. The fears we had of governments crowding out private borrowing have dissipated for the unfortunate reason that the slowness of the economic recovery that we predicted is now becoming evident. The fall of the EUR may be near its end, and has already given a boost to European competitiveness in world markets, but there is such a concept as “too much of a good thing”!

Focus

(–) USA: production prices fell 0.1% in April. Building permits dropped 11.5% in April to a level of 606,000 annually

(–) UK: inflation reached 3.7% per annum in April, its highest rate in 17 months, particularly owing to increased tobacco and alcohol taxes

(?) Europe: Euro zone GDP expanded 0.5% yoy in Q1. April inflation was 1.5% per annum

(–) Germany: the ZEW index fell to 45.8 in May, down from 53 in April

(+) India: industrial production was up in March 13.5% yoy – the seventh month of unbroken expansion

(!) Greece: the recession continues but at a slower rate of decline: - 0.8% in Q1 and - 2.3% yoy. Unemployment reached 12.1% in February

(+) Italy: the economy grew better than expected in Q1 with 0.5%. Inflation moved up notch in April to 1.5% per annum

(+) Portugal: GDP expanded 1% in Q1 over Q4 and 1.7% yoy. Unemployment reached 10.6%

(+) Brazil: retail sales 1.6% in March, well ahead of expectations, and suggesting a strong recovery for the largest Latin American economy in Q1

(?) Ireland: the drop in prices which began in January 2009 slowed to an annual rate of -2.1% in April vs.-3.1 % in March

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

Recommended average maturity for bonds (corporate/government)

Current market conditions suggest aligning government maturities with corporates.