Bond Outlook March 3 2010

A relative calm has descended on fixed-income markets. The moves to lower credit, which have been so rewarding, have gone about as far as they are likely to go. The general illiquidity which we thought was developing is now focused upon only specific areas of the market, such as dollar-bonds in Europe. The Greek concerns have, at least temporarily, subsided. It is therefore time to reflect on the forthcoming ending of quantitative easing in the USA and UK, and its ultimate reversal.

Last week we suggested that the end of Q.E. would be inflationary, and one kind reader questioned that supposition. Looking at the issue again causes us to rethink. Historically, Q.E. has always been inflationary. The actual act of a central bank buying government bonds should be inflationary as fresh money is created, neither through a rise in tax revenues, nor through borrowing on the open market. That is why Q.E. is likened to “printing money”.

At this point in time, inflation has yet to appear because the forces of recession are too great. Yet the seeds of inflation are still there, awaiting their day. In the meantime, government borrowing in the US in 2009 and 2010 will be 5 or 6 times its historic average in dollar terms. We have long said that this must lead to an increase in longer-term interest rates, and this has been reflected in bond market behaviour. DB has put actual numbers on the expected increases: 60 bps for 10-year T-Bonds and 100 bps for US mortgages, with a time horizon of autumn 2010. We are surprised at the conservative nature of these forecasts, but perhaps they are indicative of the market’s hope that such increases can be borne without a fall-back into recession. These conditions are unlikely to allow much growth, but that merely supports our expectation of an “L-shaped recession”.

If Q.E. is actually reversed (as distinct from merely being discontinued), assets on the Fed’s (particularly GSE bonds) or BoE’s balance sheet will be replaced by cash from the GSE’s and the Treasury. The arrival of inflation is then a function of when and how fast central banks allow the cash back into the economy. They certainly have to let some out to replace that being withdrawn by the Treasury through its borrowing, however much will merely be destined for the payment of interest, largely to foreign creditors. Release too little and the recession returns. Release too much and inflation takes off. We see a strong chance of the erring towards ‘too much’, not least because it is the only weapon governments possess to bring debt to GDP ratios back to reasonable proportions.

The remarkable thing about the EUR crisis is that the common currency has not fallen further against the USD. That says a lot about the USD’s own problems as an inherently weak currency.

With a wry smile, we notice a new name for the folk who take taxpayers’ money for bonuses, and for having helped Greece deceive the whole world: “banksters”.

Our recommendation to remain at short average maturities has been unchanged for months, and we see little reason to change our tune at this juncture

Focus

(–) USA: sales of new homes fell 11.2% in January. February new registrations for unemployment were 496,000. Household revenues rose by 0.1%, while construction expenditure declined a further 0.6% after the 1.2% fall in December. The ISM manufacturing index in February came in at 56.5 whereas analysts expected 57.5

(+) Euro Zone: even though the business confidence index declined to 95.9 in February from 96.0 in January, the manufacturing index improved to 54.2, vs. 52.4 in January, the highest in 30 months

(+) Russia: GDP expanded 5.8% yoy in January.

(+) Australia: the RBA raised its interest rate by 25 bps to 4%

(–) Sweden: unexpectedly the economy fell back into recession in Q4 (minus 0.6% on Q3)

(+) Canada: GDP grew 5% yoy in Q4 thanks to higher household consumption and exports

(+) Switzerland: after three months of GDP decline, Q4 saw the economy return to growth at 0.7%

(+) India: exports advanced 11.5% yoy in January, the third month of expansion

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

Recommended average maturity for bonds.

Stay short across the board.