Bond Outlook February 28th

Our comments over the last fortnight on the US sub-prime mortgage market, housing linked economic sectors, the JPY and the carry trade, the de facto linkage of the CHF to the JPY (via the carry trade) and the rude health of the Swiss economy have all proven correct more quickly than we ourselves could have imagined. Last week we could observe that stock markets and the US retail trade were ignoring these issues; this week all have been taken on board. Now the question facing all investors – and this stands whether or not some recovery occurs--is whether this is a minor correction or a sea-change.

The Chinese stock market was the apparent trigger for the current stock market declines. It can be debated whether the fall in the Chinese market was a purely internal affair or a result of reflection about a fall in US demand for Chinese goods. It hardly matters, compared with two root causes at last being taken seriously:

• The vulnerability of US housing market being exposed by the losses and bankruptcies in the sub-prime mortgage industry, and the knock-on effect on durables
• The rise in Japanese interest rates leading to a strengthening of the JPY and the unwinding of the JPY (and CHF) carry-trade

Are these two phenomena here to stay and strengthen? Our view is “probably, yes”, for the following reasons:

On housing:

• Although the sub-prime market has proven the soft underbelly of the housing bubble, the impact of lower household purchasing power from a reduction of mortgage equity withdrawal has yet to be felt.