Bond Outlook [by bridport & cie, October 8th 2003]

Post-G7, the event we saw as the "end-summer break" that we were looking for, a certain trend has set in: a steadily weakening dollar and strengthening yen, continued but weaker upward pressure on the euro, and higher yields across the board. In trading terms our recommendation of marginal lengthening in euros and CHF was too early, but our investment view is that USD yields must rise still more and EUR yields fall. The fundamental differences between the two economies should logically lead to an uncoupling of interest rates, but the "tradition" that Europe merely follows meekly where the USA leads is going to be hard to break.


Last week we had to deal with a loss of confidence in the US recovery, this week, to judge by the equity markets, confidence has returned. We do not share it, neither do most economic commentators, but for this week at least, the pro-Bush propagandists are ahead. The 57,000 extra jobs were greeted like the greatest news in months; never mind that growth in the US working population requires almost double that number of new jobs for unemployment not to increase.


For years we have been astounded by the willingness of the US consumer to spend, increasing household debt to do so. It does not require great foresight to realise that a small increase in interest rates on a small base washes through to a sharply increased interest burden. It is as if the obvious does not occur to the US consumer until it actually happens.


The obvious has happened. Interest charges have gone up, and re-mortgaging, a nice source of fresh cash for spending, has lost its attraction. The cash-in-the pocket of the summer tax cuts has been spent, so there is nowhere for the consumer to turn to continue his or her spendthrift ways. This should lead to the consumer increasing savings rates and to decreasing household indebtedness. The published data suggest that this is happening. The trough at 2% savings rate was finally left behind at end 2002 and the rate is now 1 percentage point higher. Consumer credit as a proportion of disposable income has also receded by a percentage point from its peak of almost 25%. Add to this the cheaper dollar, and there are now two tentative elements of the beginning of rebalancing which we enumerated in early 2000 (the others were Federal deficit, corporate debt, overvalued equities and the external deficit). Still a long way to go, especially as the Administration policy opposes all these rebalancing moves. It is only our faith in market forces that lets us anticipate eventual rebalancing and that a new, healthy economy will eventually emerge despite, not because of, US economic policy. But when? In 2000, we said ten years, and we see no reason to change that horizon.


The bond market has turned rather quiet at the moment. We are seeing some clients put on smart trading strategies, and there is a general search for yield while massive shifts in yield curves are not expected in the immediate future. The trend to higher USD yields is well established (and we see this partly as the other side of the dollar devaluation coin). Our concept (and it is not only ours) that Euroland could uncouple for the USA on interest rates is yet unproven, although we affirm that the euro zone cannot afford both a stronger currency and higher rates. Whether such uncoupling will happen will have to wait until Trichet begins his reign.


Many months ago we warned readers about the risk of illiquidity in the then much-vaunted structured products. Such products have indeed proven extremely illiquid, and there is not much to do except let them run to maturity; there is simply no market, not even from the original sponsors of these issues.


Periods like the current calm are often followed by a major shift. From our argument above it could come from the US consumer setting the example to the Administration about not spending beyond one's means. It could also come from more currency realignment, including the euro making a serious bid (if Trichet likes the idea) to share the burden and privilege of being a reserve currency.


Recommended average maturity for bonds in each currency


Generally stay short, but new cash going a little longer in euros and Swiss Francs.

As of 01.10.03
As of 30.07.03

Dr. Roy Damary
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