Bond Outlook by bridport & cie, January 12 2011

Opinion is totally divided as to whether the euro zone will successfully deal with its crisis. Our view is to remain sanguine, given that, in the short term, the commitment of the strong countries appears unshakable. Germany is doing so well economically that it can afford the bail-outs. Japan is joining China in galloping to the rescue by purchasing EUR bonds. The peripheral countries are managing their financing roll-overs.

In addition, an important step in finding a long-term solution has been taken through the issuance by the EFSF of its first “Euro zone bonds”, a move we suggested would occur when it was first established. We see this as a step towards the “federalisation” of euro zone government debt. There are many unanswered questions about this process, including whether individual countries may, or should, restructure (we would expect there to be such a mechanism, certainly for bank debt, and possibly even for sovereigns).

The EU Economic and Monetary Affairs Commissioner Olli Rehn’s statement sums up neatly the commitment of EU leaders; “Our most pressing priority is to break the vicious circle of unsustainable debt, financial turbulence and sub-optimal growth.”

Whenever a structure is in place with an explicit or implicit bail-out mechanism, moral hazard is present (irresponsible lending relying on centralised bail-outs). The savings bank crisis in the USA, the “Greenscam put”, Greek and Irish profligacy, and even closer to home, Geneva’s Cantonal Bank, being prime examples. However, we believe that the moral hazard can be reduced within the euro zone, not least by a mechanism to put the risk of bail-outs on private, as well as on taxpayer, shoulders.

Obviously the interest of China and Japan in assisting the EUR stems from their wish to maintain the strength of their exports markets. Some suggest other agendas, such as the search for technology, but it is hard to see how buying bonds gives access to technology. Both countries also desire a second major reserve currency just to alleviate their dependence on the USD.

As readers will know, we remain sceptical about the foundations of the recovery in the USA. The basic problems of the declining property markets and deficit spending are unresolved, although a glimmer of hope has appeared in the proposed cuts in military spending.

We would now add a new theme to our frequent comparison and contrasting of the US and European responses to the recession: the origin, direction, and ongoing flow, of their respective crises. In Europe, the problems arose in profligate peripheral countries and “moved up” within the structure of the euro zone, leading to bail-outs and to what we call “federalisation”. In the USA, the problems are trickling down from Federal Government to the States and Municipalities. Deficit reduction at Federal level has reduced the subsidies to States. In turn, the States are reducing their subsidies to cities and counties, just when the declines in property taxes are beginning to hurt.

The Build America Bond (BAB) programme has ended. This was an attractive source of funding for municipalities as the Treasury gave a subsidy of 35% of the interest cost, and the programme was open to foreign investors. Municipalities are now having to rely much more heavily on their own resources, and will have to issue more bonds to finance their budgets. This should lead to an increase in yields – and it has – but, curiously enough, issuance is apparently down as the year begins, although the reason for this may simply lie in the high issuance rate at the end of 2010. As municipalities are forced to raise funds and pay higher yields, either their indebtedness will worsen, or the cut-backs in local services will steepen.

In the meantime, all the repercussions of the “currency war”, rising food and energy prices and inflation in emerging markets, remain unresolved. We can but commit to follow them closely.

Market Focus

• US: Unemployment dropped to 9.40% as payrolls increased by 103,000. Corporate bond sales hit a record last week at $48.2 billion and relative yields on investment-grade debt shrank to the narrowest since May. U.S. corporations are set to report their most profitable fourth quarter on record. Wall Street banks are cutting their holdings of Treasuries at the fastest pace since 2004, betting on increasing demand for higher-yielding assets

• Portugal: The first of Europe’s high-deficit nations to test investor demand in 2011 sold EUR 500 million six-month bills. It then sold EUR 599 million of bonds due in 2020 at a yield of 6.716 % and EUR 650 million of bonds due in 2014 at a yield of 5.396 %. This is considered a moderate success

• Europe: Services and manufacturing industries expanded in December led by Germany, where factory orders rose, driven by demand from outside the euro region. Orders, adjusted for seasonal swings and inflation, surged 5.2 percent from October, when they gained 1.6 percent

• Banks: The European Commission published a paper on how to deal with future bank failures: minimise the risks of contagion, protect retail depositors and avoid any costly bailouts by the taxpayer. S&P requested comment on a new methodology for rating banks, a bottom-up approach compared to the top-down profile used beforehand. The impact will be modest. An EU report suggests that 10 new bank taxes could see some of Europe's largest banks lose up to 25% of profits

• Switzerland: Inflation accelerated in December on rising oil prices. Consumer prices advanced 0.5 percent from a year earlier after increasing 0.2 percent in November. The jobless rate remained steady in December at 3.6 %

• China: For the first time since 2008, Chinese companies are paying less to borrow for 15 years than for 5, reflecting a shortage of longer-dated debt and confidence policy makers will curb inflation. For the first time over half of Chinese exports (56%) are to areas other than the USA or Europe

• Brazil: Several measures, including widening the futures market, are being taken to moderate the rise in the Real exchange rate

Disclaimer
This document is based on sources believed to be reliable, accurate and complete. Any information in this document is purely indicative. This document is not a contractual document and/or any form of recommendation. Expressions of opinion herein are subject to change without notice. We strongly advise prospective investors to consider the suitability of the financial instruments, based on the risks inherent to the product and based on their own judgment. It is not intended for publication. This document may not be passed on or disclosed to any other third party without the prior consent of bridport & cie s.a. © bridport & cie s.a.

January 12th 2011

Dr. Roy Damary