Bond Outlook by bridport & cie, July 11 2012

As usual, the signs of economic improvement last week were short lived. In a strange way, the lower repo rate of the ECB has worsened the functioning of banks in Europe. We explained in our Weekly of June 20th how the ECB system of reverse repo (LTRO) had led to a shortage of bond inventory, and to the contraction of lending (both cash and securities) between banks. Now that short-term interest rates are even lower, banks have simply ceased their money market operations. Yet the funds that would have gone into money markets are still seeking a safe home – safer at least than the banks themselves! – and the only place left is short-term government bonds. It was easy to explain negative short-term rates for German and Swiss government bonds, but it takes the closing of money market funds to explain it for French government bonds!

It is not obvious why anyone would want to see their capital fall in value, rather than leave it intact at a bank, or why banks themselves feel obliged to use their cash to buy short-term negative-interest bonds. The only explanation is that suspicion has grown to such an extent (even between banks themselves) that a small guaranteed loss of capital is seen as preferable to a much larger potential loss should things deteriorate further. Some say they should be “forced” to lend to each other and to companies, but there is no legal mechanism for this. Better to hope that the EU steps to disentangle the banking from the sovereign debt crisis eventually bear fruit.

In the meantime, do we all realise that Germany is continually bailing out the peripheral countries despite Merkel’s seven neins? The bail-out mechanism carries the moniker “Target2”, and has been in place, but largely unnoticed, since the euro was established (our thanks to Andrew Hunt for this insight). It aims to ensure a balanced flow of funds within the currency union between deficit and surplus countries. The country with by far the largest intra-zone surplus, Germany, with its Bundesbank, is at the heart of the system. Already the German trade surplus is in the order of EUR 20 billion per year, but, in addition to this, large capital inflows are now taking place, estimated at around EUR 40 billion (these data are indicative only). The combined figure of EUR 60 billion per year may even be too low during this period of mistrust of the peripheral countries and banks in general.

Euros flow into the Bundesbank, are sent onwards to the ECB, and then back out to the central banks of deficit countries, which lend to domestic banks or buy domestic sovereign bonds. There is apparently no limit to the amounts that are thus recycled, so that the incentive for the deficit countries to deflate is lacking. There may be other forces obliging austerity, such as bail-out agreements using funds other than via the Target2 system, but the opaque Target2 has on the one hand allowed the euro zone to function so far, but has also alleviated the pressure on deficit countries to seek external balance. Target2 has thus become a key factor encouraging irresponsibility – all part of the fundamental rethink of the EMU which is now slowly getting underway.

There are parallels between Target2 and the US system called “Fedwire”, but with more incentive for the Fed “Regions” (which each cover several States) to seek balance through regional deflation and austerity.

Our own clients are still focused on corporate bonds, seeking yield, but still within investment grade parameters.

Macro Focus

United States

The IMF has lowered its growth forecast for 2012 to 2% (vs. 2.1%) and 2.4% to 2.25% in 2013, reflecting a high risk of slowdown due to the European financial crisis and uncertainty on fiscal matters

France

The Treasury has raised € 1,750 billion maturing October 25, 2019, at a rate of 2.02%, against 2.48% in the last similar operation on March 1. It also borrowed nearly € 6 billion short-term at negative rates for 3 and 6 months (-0.005 and -0.006%)

Switzerland

The number of bankruptcies increased by 8.9%, during the first half of this year. The phenomenon affects individuals more than companies

Australia

Retail sales in Australia rose by 0.5% in May (against 0.2% expected), mainly accounted for by expenditure in restaurants and stores

Brazil

The country plans to maintain the pace of interest-rate reduction by half a percentage point each quarter as a means of countering lower economic growth than expected and the European financial crisis

China

Official Chinese statistics may be out of step with independent analyses. According to a new private study based on the model of the Fed's Beige Book the previous quarter witnessed a recovery