Bond Outlook June 16 2010

Calm has descended on financial markets, but whether that is because of the World Cup or a reflection of a return to genuine stability is unclear. What is now clear, however, is that our description of the recession as “L-shaped”, or to use John Mauldin’s phrase, resulting in a “Muddle-through Economy”, is widely accepted as a fair description of the current economic state of affairs. Bernanke himself says as much but in that special banker’s language which softens the impact of an otherwise strong statement. He talks of a structural budget gap on an unsustainable path. Thus the current calm, welcome though it is, cannot last very long.

Governments and central banks continue to walk a tightrope between inflation (actually “stagflation” as it is “cost-push” rather than “demand-pull”) and deflation. Inflation threatens if stimulus is renewed or expanded; deflation if retrenchment (higher interest rates, selling bonds back to the open market) is introduced too soon. We see inflation delayed by months or even years, with low interest rates and low inflation for the medium-term future.