Bond Outlook March 29th

The foreseeable increase to a 4.75% Fed rate has been announced, and stock markets have duly corrected. 5% remains the likely target, and the debate is now whether it will be the ceiling. Bernanke’s wish to drag the 10-year yield up with the overnight rate has been fulfilled. Perhaps the most interesting aspect of this rate rise is what did not happen: no significant rise in USD exchange rates against the major currencies (plenty against the minor), no let up in Chinese buying of T-Bonds, which has led China to be ahead of Japan in their T-Bond holdings, no slowing of US household borrowing.

Yet Bernanke must be wanting to reduce household indebtedness, which in 2005 grew faster than that of all levels of government combined ($ 650 vs. $ 450 billion). Our sense is that the Fed will not stop at 5% unless household borrowing does significantly slow. Both the defenders of the US economic paradigm and its detractors have become more shrill, and fixed-income investors more than a little cautious. Higher T-Bond yields are necessarily reducing the urgency of the search for yield in emerging markets and higher yielding currencies. The positive fundamentals of most emerging markets – trade surpluses, high commodity prices, buy-backs of external debt, internationalisation of domestic debt – are limiting the damage to EM bonds. However, the higher yielding currencies of developed economies are suffering. The Icelandic Krona has been the first victim of this disenchantment, but is unlikely to be the last.

Carry trades – borrowing in a low-interest currency to invest in a higher-interest one – are losing favour. Their base currency is also shifting somewhat from the JPY to the CHF. When a currency is borrowed to buy foreign assets, the sale of the borrowed funds acts to weaken the currency. That may explain the decline of the CHF from 1.55 to 1.57 to the EUR. On the other hand unwinding carry trades should have the opposite effect on the JPY - it has just not happened yet!

Allow us to return to our persistent themes of the two economic fault lines: the US housing bubble and the Chinese support of the USD. For the former, data can found to support both views: new housing sales are declining but sales of existing houses are rising. The housing fault line is still the one we see as cracking first.

The Chinese fault line is working through more slowly, but steadily and inevitably. Chinese economic rebalancing – so clearly spelt out by Stephen Roach of MSI – will mean more domestic demand, reduced reliance on exports for growth, lower dollar surpluses to recycle, and government interest in allowing a stronger RMB to encourage domestic consumption. The day the Chinese Government decides that it no longer needs to hold down the RMB against the USD, the pressure on the USD will be enormous. We can remain sanguine only to the extent that the Chinese leaders are able and willing to allow the change to happen in a controlled way.

In the meantime, India is on the rise. The rupee is widely seen as destined to appreciate. The country has the human capital but its infrastructure is crying out for investment. India has gradually thrown off its self-imposed constraint of not seeking foreign capital. Our expectation is that the mooted convertibility of the rupee will be followed by an infrastructure investment programme that will suck in much of the world’s surplus liquidity towards the end of this decade.

That surplus is already declining with the trend to higher interest rates everywhere, including Euroland, where the optimism of Germany is seen as favouring a higher ECB rate. The outcome of the French confrontation now has a huge symbolic significance – who runs the country? The really violent demonstrations have come down to a few hundred hooligans enjoying a fight with the police. The public sector strikes are where the real battle of wills is underway.

Fixed-income investors are (and should be) in a “play safe” mode, at least until the Fed rate reaches 5% and the overall outlook can be reconsidered.

Recommended average maturity for bonds in each currency

No change to recommendation to stay with bar-belling for CHF and EUR.