Bond Outlook December 9 2009

The Fed, according to Bernanke, is committed to keeping inflation low, and stands ready to raise the overnight rate at the first sign of inflation. It has two new tools to put a floor under the inter-bank lending rate: reverse repo and the payment of interest on banks’ deposits at the Fed. At the risk of wanting to find confirmation of our forecasts since the beginning of the recession, the best that can be expected, now that economic decline has been arrested, is a flat economy in the USA and most Western countries, or, at the most optimistic, very modest growth. GDP growth will not in fact even keep up with population expansion, implying a general decline in living standards.

As an independent commentator we can spell out what Bernanke can only hint at in his presentations:

• this recovery is dependent on stimulus packages, which have to be first reduced, and then withdrawn
• if they are withdrawn even a fraction too early or too late, the economy will slide back into recession
• should growth move back to historical levels of, for example, 3%+ per year, inflation will be let out of the bag because so much money has been created (“printed”) through quantitative easing without sound underpinning
• Bernanke recognises that American overspending has now to give way to belt tightening as part of the process of world economic rebalancing
• he sees the economy “facing formidable headwinds”
• the Fed has played its part in the bail-out process and is now switching its mode to inflation (read “growth”) containment

These last two points seem contradictory: on the one hand, “formidable headwinds” (Bernanke’s own words) and being prepared to hold the Fed rate low as long as necessary, and on the other, a willingness to tighten to curtail growth further. It almost seems that whether he stresses keeping rates low or threatens to raise them depends on the day of the week! He must indeed steer the ship of the economy between Carrybde and Scylia (double dip and inflation). How serious he is in wanting to avoid inflation may be open to question, but we must admit his words express great commitment. If events transpire as he has forecast, then highly constrained growth will be the pattern for years to come.

He could of course still change his mind and allow greater growth and inflation, but currently, we can scarcely doubt his preference for slow growth.

We have long argued that long-term yields will increase in 2010, while short-term rates remain anchored. On balance however, Bernanke’s recent speeches suggest that the Fed may weigh anchor sooner that we thought. Either way, the yield curve will steepen. Even if the overnight rate moves, for example, to 1% in the coming months, the longer end will rise by at least the same amount, and it is that which is drives our recommendation to maintain short maturities.

Fixed-income investors, in fact any investors, face a dilemma: keep their funds safe but poorly rewarded or take risks (stock market, low-credit, long bond maturities) to achieve some return. We prefer short maturities to avoid losing the opportunity of higher yields at some point in 2010, and, for those seeking a slightly higher risk/reward play, we lean toward the bonds of commodity producing countries, such as Brazil and South Africa.

Obama must be finding some relief from the spare and repaid TARP funds. Among his choices (do nothing and reduce the deficit vs. more stimulus) he may soon find that he has little option but to rescue many individual States which appear quite incapable of balancing their budgets.

Fears of the Dubai crisis spreading are waning, although just about everything associated with Dubai is now tarnished, not least because so little information is forthcoming from officials. Beyond the Emirate, confidence in “quasi-sovereign” bonds has been damaged, and it may be asked whether Islamic “sukuks” will retain the attraction they once had.

Focus

(+) USA: Citi seeking to join other major banks in repaying Tarp funds early. Slight decline in unemployment (10.2% to 10%); improvement mainly via temporary service employment and health

(–) Greece: the downgrading will lead to a draconian cut-back in government spending as bail-out within the euro zone will be far from unconditional

(?) Europe: producer prices in the euro zone increased by 0.2% in October, and GDP by 0.4% (in the EU as a whole the expansion was 0.3%). However, German industrial orders in Q3 were down 2.1% on Q2

(!) Japan: new stimulus package of JPY 24.4 trillion (EUR 184 billion) without major borrowing (must be “printing money”?)

(!) Ratings: Moody’s say USA and UK may “test the Aaa boundaries” because of worsening deficits

(+) positive for bonds (–) negative for bonds (!) watch out (?) begs the question

Recommended average maturity for bonds.

Stay short across the board.

Currency:

USD

GBP

EUR

CHF

As of 17.06.09

2012

2012

2012

2012

As of 21.01.09

Max. 2013

Max. 2013

Max. 2013

Max. 2013

Dr. Roy Damary