Bond Outlook [by bridport & cie, October 2nd 2002]

Dear Readers,


So we have been "Austrian" all along! After fifty years of being ignored, the economists of the last years of the Austro-Hungarian Empire, most of whom ended up in the USA, are again la mode. In amongst all their arguments about the relations between individuals and society and the superiority of the free-market system over central planning, lies the gem that easy credit, combined with increased expectations of profits, leads to over-investment and excess production capacity. This tendency is encouraged by low inflation, which in turns removes the incentive for Central Banks to raise interest rates. Indeed, the Banks have been told by politicians to focus on inflation rates, with a sideways glance (in the case of the Fed) at overheating. It is therefore scarcely surprising that they ignored the issue of over-investment, and, even if they had tried to prevent it, political opposition would have overwhelmed them.


As we (and others) have pointed out in recent weeks, the Central Bankers are fighting yesterday's war against inflation instead of today's battle against deflation. They play according to the rules of modified Keynesianism, which has worked well when excessive demand created inflation and insufficient demand recession. Now, just as the wrong type of snow stopped trains running in the UK a few years back, this is the wrong type of recession. The recipe of ever looser money supply, as in Japan, cannot turn an economy round because corporations cannot do anything useful with new funds. Consumers and the Government can use new funds, but the productive side of the economy cannot.


Many corporate bond offerings have been withdrawn recently. At first sight, this might mean that the demand is inadequate at the spreads offered and that corporations cannot afford to pay more. True. Consider, however, that there have been fewer corporate bond offerings this year, and that the recent cancellations suggest no particular need for new money. HP, for example, cited market conditions, but added that the company has no urgent financing needs. Of course not! At a macro-economic level, corporate borrowing must fall from its current 42% of GDP (for non-financials). At the micro-economic level, cleaning up balance sheets and refraining from unproductive investments is driving most companies.


Only one thing can solve the problems of the laxity of the US Administration and the Fed, viz., time. Time to allow savings to recover, the balance of trade to improve and asset values to return to long-term trends. Time will however work its magic better if, in addition, the dollar is allowed to weaken enough to improve the balance of trade.


Meanwhile in Europe, Governments rival the Japanese for their inaction. Nevertheless, we admire the new taxation system being introduced by Italy, where income tax now works as follows: earnings are deposited in Swiss banks and sit there making modest returns in CHF for a few years. In due course, the owners are granted an amnesty. The old money returns to the Italian economy and the whole cycle begins again. Net result: income tax of between 2 and 4%…


The confusion created by stock market volatility and hopes that a bottom has been found have repercussions on bond strategy and prices. Our clients have indeed been pulling in different directions. Some perceive bonds as overbought and have begun profit taking. Others believe more in waiting till a much more solid bottom is built for the stock markets. If there is a trend, it is from financial corporate bonds to non-financial.


Our view has been and still is that the fundamentals are against economic recovery (e.g. still rising unemployment, contracting manufacture, declining profits, excessive indebtedness). It is hard to imagine a stock market moving in the opposite direction of the fundamentals when valuations as a function of earnings and their outlook are still so high. Add to that the wrong diagnosis of the governments, and conclusions of the "Austrians" is incontrovertible: a recession is an unavoidable, but necessary evil.


The American consumers remain heroic is in their endless spending. How sad that the air they are all the time blowing into the economy is not only leaking but also preventing the cure needed for durable recovery.


In the smaller world of European bonds, the attraction of Norway and its currency, already apparent for many weeks, remains strong. The reach of Baghdad via oil prices is a long one!


Recommended average maturity for bonds in each currency.
Remain long across the board, except in Sterling

As of 10.07.02

Dr. Roy Damary

Currencies (by GNI)


The FOMC and the BoJ decided to leave interest rates unchanged, the ECB continues to think monetary policy as being adequate, and all this in a still very weak economic environment. However, the SNB made it very clear that, if the CHF should continue to strengthen, some extraordinary measures will be applied. (negative short term interest rates or, in extreme situations, open market currency intervention). The most likely outcome in the weeks ahead is for continued range trading. Market participants are getting excited each time at the top or at the bottom, finally hoping for a break out. All recent comments on the various currency pairs remain valid.


EUR/USD: A broad trading range of 0.9580/0.9610 and 0.9980/1.0020 still looks valid. A clear break on either side would be good for at least 150 to 200 points.


USD/CHF: Here, it looks like that the market has some interest to buy USD around 1.4700 and to sell them between 1.5250 and 1.5330. Only a clear break on either side would open the door for a move of at least 200 points.


USD/JPY: The 120.30/50 is becoming major support, and any break would again speak for the old trading range of 115.50 to 120.00. As stated last week, the 123.50 to 124.00 zone is acting as strong resistance, with major selling interest by the export community.


EUR/JPY: The market finally managed to break the 119.60 resistance zone and confirmed the break out from its old trading range of 115.50 to 119.50. However, the air is getting thin above 122.00 and most probably some consolidation will be seen between 120.00 and 122.00.


USD/CAD: The CAD continues its weak behaviour as it seeks to establish itself above the support of 1.5780 but still eyeing the 1.6000 area. We prefer to wait to establish our long CAD short USD position until we have a clearer view of how the US is going to perform economically.


AUD/USD: Same comment: it looks like that the Aussie is still struggling to sustain levels above 0.5500 for very long. Consolidation in a 0.5350 to 0.5550 range is to be expected until further notice.



Current spot level
Current spot level

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