Bond Outlook [by bridport & cie, August 7th 2002]

Just a few weeks ago we were arguing that general expectations of a rise in interest rates were premature, but supposed that the next move would be upward, probably led by the UK because of the fears about a housing price bubble in that country. Now, it seems that we were too optimistic in supposing that the poor economic fundamentals would merely slow rate hikes. This week the talk is about lowering rates, with the US showing the way, the UK following and the ECB bringing up the rear. It is even alleged that stock markets rallies in this bear market reflect a growing belief in a rate cut. However, we prefer to understand the extreme volatility of the markets as a reflection of share prices being in "no-man's land" - neither "new economy" nor "old economy" valuations.


We incline to the expectation that the FED will loosen further, although whether it will do any good is a different matter. Stocks will probably rally until it is realised that the reason for the cut is the poor fundamentals. Long-term readers will remember our " not by interest rates alone" comment made two years ago on how to bring about a lasting US economic recovery. It still applies. Private, public and national debt must be rebalanced. The USA is living beyond its means, huge though they may be.


Deflation is the great danger facing the US economy, and, by extension, the world's. When an economy is only spluttering along with short-term rates at only 1.75%, it is already a sign of poor fundamentals. A further cut will but show the situation to be worse, even Japan-like. No, it will not be quite that bad, because the USA does not have the same problem of a non-spending elderly population. It does, however, have a baby boom generation coming up to retirement, and feeling extremely unhappy and unsure about their pensions as so many 401K's (private pensions with the option of large equity exposure) lose value inexorably. The resilience of American consumers (some might say irresponsibility, but, after all, they are only doing what the Administration asks), in spending despite a poor economy is remarkable, but even they cannot resist indefinitely. Spending must turn into saving - good in the long run, bad in the short.


The USA also needs time for rebalancing. Companies and, well behind them, households are working their way out of debt - a good thing, but it requires time. The lower dollar will help bring international trade nearer balance, but it takes time. Even stock market valuations will return to historical bases - but it takes time (may we remind readers of our observation last week that SP 500 average PEs are still higher than when share prices were at their peak). The sad thing is that the Administration cannot face the need for time; it wants and encourages the American people to believe in instant cures. Such speedy recovery is just not possible after the excesses of recent years, epitomised by the accounting scandals. For this reason, tighter rules on financial reporting, necessary though they be, will not bring the bear market to an end. A more subtle change in boardrooms will be part of the return to health: a return to the basics of making profits from satisfying customers. Less hype and more real bottom line. Less acquisitions and more organic growth. For those of us with long memories, more of the style of the late Lord Weinstock and Harold Geneen. We would also propose that time is needed by the rest of the world to become less dependent on US deficit-based demand for goods.


In addition to the need for time to repair the self-inflicted damage to the US economy, there is another powerful argument in favour of our view that this whole decade will be one of modest growth and returns. The entire debt structure of the USA would come tumbling down if ever the economy recovered so quickly that interest rates had to be raised to dampen inflation. If the USA climbed too quickly out of this hole, it would fall straight back in again. A slow clamber out is definitely indicated! Europe should be seizing the opportunity to show economic leadership. However, the timing of the French move to the right (just before the summer break) and of the German election means that not much progress may be expected until later in the year.


Our fears about Brazil are not exactly put at rest by Paul O'Neill allegedly making up for his gaffe. When a country has a friend like him, it needs no enemies!


No change in our recommendations of maturities is needed, although we have clients moving in both directions: to cash in case equities turn round, and to 30-year maturities in case they do not!


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

As of 10.07.02

Dr. Roy Damary

Currencies (by GNI)


The UD dollar held up very well last week, despite the three consecutive falls of the US stock markets on Thursday, Friday, and Monday. Yesterday, the good performance of the stock markets helped the USD to go a little further up. We observed yesterday an inverse movement from last week's: investors were selling European bonds and buying back their short positions in US shares. If this scenario could continue, the major USD repatriation should more than support the dollar. The situation in Latin America remains fragile. Brazil seems confident on the negotiations with the IMF and the USD/BRL came back a little after the sharp move of last week.


EUR/USD: Contrary to our expectations, the euro slid below 0.9750 and went through 0.9675. At the current level, we suggest to keeping a close eye on the market. A daily close below 0.9620 should announce at least 0.9525. In the other direction, a quick come back above 0.9750 is needed to target 0.9900 and return to last week's bullish scenario.


USD/CHF: Our favoured scenario was not correct, but, at least, as announced, the break of 1.4950 pushed the greenback directly to 1.5100 (1.5140 at the top). If the movement continues, a break of 1.5150 should open 1.5300. A rapid return below 1.4950 would mean it was a false break.


USD/JPY: The exchange rate is flirting with its resistance at 120.80 (see last week's comment). A daily close above 121.00 should allow the dollar to reach 122.75.


EUR/JPY: Key support is at 116.40. A clear break there should provoke a movement of at least a 100 pips.


USD/CAD: We clearly missed our target and have been stopped at 1.5900 (50 pips profit). Support is at 1.5800 and resistance 1.6050.


AUD/USD: A clear break of 0.5350 is needed to be bullish and re-target 0.5500. Support is at 0.5250.



Current spot level
Current spot level
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