| Long ago we pointed out that quantitative easing, whether it be direct, as in the USA and the UK, or indirect as in the euro zone, was planting the seeds for inflation. We also suggested that the end of QE would see the yield curve steepen as sovereign borrowers competed directly with corporations in bond markets. The reason these events have not yet come to pass is that the economic outlook has been so poor that the cash created by QE is being used by consumers for debt reduction, or, in the case of corporations, is simply being hoarded. |
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| The economic outlook is now more encouraging. “M&M” (Merkel and Monti) are going public with their assurances that the crisis is ebbing, and the ECB sees no need for more LTRO. Curiously enough, Bernanke is the one expressing the most caution with his “too early to declare victory”. Merkel has even warned that Bund yields are likely to rise. The same seems to be happening to T-Bonds, despite the Fed’s intervention along the entire yield curve to the point that some describe as “manipulation”. We may reasonably conclude that so long as the recovery, anaemic though it is, continues, there will be upward pressure on government bond yields, apart from, that is, for the usual suspects in the euro zone. |
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| The implication for fixed-income investors is of course that long-term quality government bonds will see lower prices – always assuming the recovery continues. The repercussions on corporate credit are less obvious. It can be argued that the current “risk on” climate will cause spreads to decline even further, compensating for the steepening of the government curve. The counter-argument is that corporate spreads have come in so far that the risk/ reward outlook has become unattractive; spreads will at best remain at current levels, implying a loss in value if our overall expectation of a steepening yield curve comes to pass. Readers are asked to forgive us for not favouring one outcome or the other, not least because the decision needs taking for each bond individually. We affirm however that long maturities run a greater interest-rate risk than the middle of the yield curve. |
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| The likelihood of higher yields for better quality government bonds in the euro zone has implications for banks. As highlighted by the FT, a significant proportion of the LTRO funds not being deposited back in the ECB are being used to buy government debt in the banks’ own countries. Paradoxically, it is the banks of the stronger countries which will lose the most with increasing yields, while those of the weaker countries are likely to benefit from the falling yields of their government bonds. |
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| LTRO has indubitably settled the atmosphere in and about the euro zone, and is indeed a remarkable gift to banks. Some suggest that the ECB loans reduce the pressure to restructure balance sheets. Similarly, it may be questioned how the banks will repay their debts to the ECB after the three years. A new cycle of ECB credit perhaps? This all reinforces our view that most Western economies are still dependent on extra-ordinary government support. We would not, at this point, say that the support should be removed – it was essential once the implications of spending beyond means became apparent. It is worth recalling however that two milestones must be passed before the economy is seriously on the mend: home prices in the USA need to start rising, and banks everywhere need weaning off cheap central bank money. In addition, of course, the USA must reduce its government deficit, but little is likely to happen in that direction until the Presidential election is over. |
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Macro Focus |
| USA: the Conference Board’s index of U.S. leading indicators for the next three to six months rose in February the most in 11 months, by 0.7 % after a revised 0.2 % gain in January. Student-loan debt reached the $1 trillion mark, exceeding the country’s credit-card debt, as young borrowers struggle to keep up with soaring tuition costs. Bernanke is encouraged by the unemployment rate’s decline to 8.3%, but sees accommodative monetary policy needed to make further progress |
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| Euro zone: services and manufacturing output contracted in March, and, overall, the PMI Composite index of business confidence declined a little (from 49.3 in February to 48.7), although it held up in Germany. Nevertheless, euro-area consumer confidence improved in March for a third straight month, notably in France. European policy makers seem unlikely to extend a third round of LTRO loans to the region’s banks |
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| Portugal: government bonds gained as borrowing costs fell at its first auction in more than a month. The Troika report confirms the 2012 deficit goal as equal to 4.5% of GDP, a remarkable 2011-12 fiscal adjustment. The mission finds no sign of “reform fatigue” |
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| Spain: banks are using loans from the European Central Bank to buy domestic government debt. Nevertheless, 10-year yields have climbed back above 5 % in recent weeks. Investments in government debt by Spanish banks climbed from € 178 billion in November to a record € 230 billion in January |
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| Greece: Prime Minister Papademos won parliamentary approval for a new € 130 billion international bailout |
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| UK: data were disappointing. Consumer confidence declined from 47 in January to 44 on rising joblessness and weak economic growth. Retail sales also fell 0.8 % from January, the most in nine months. The U.K. debt agency said in a statement it will sell £ 167.7 billion of gilts in the next fiscal year, compared with an estimate of £ 180 billion in a median forecast of 19 of 21 primary dealers |
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| Switzerland: the KOF economic research institute raised its forecast for Swiss economic growth in 2012 from 0.2% in December to 0.8%, while leaving next year’s growth unchanged at 1.9 %. The UBS consumption indicator, a gauge of Swiss consumer demand, declined for a second month in February to 0.87 points from a revised 0.93 points in January |
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| Brazil: the Real is posting the biggest decline among major currencies this month, as the government steps up efforts to protect exporters in Latin America’s biggest economy |