Bond Outlook [by bridport & cie, September 10th 2003]

The major end-summer break-out that we have been expecting has not yet happened, but the fracture lines in the current economic picture are becoming clearer.


The most obvious, and which is becoming apparent to the US public and to commentators, if not yet to investors, is that the US recovery is not creating jobs. Additional military spending is a major component of GDP expansion and does not wash through the economy in the same way as, for example, industrial investment. The additional money consumers have in their pockets from tax rebates and from remortgaging is in its last throes. The upward pressure on interest rates imposes a severe limit on industrial investment (the missing element to achieve sustainability), but of which there is still little sign.


The second is that the dollar's relative strength and the financing of the Federal deficit is very dependent on intervention cum T-bond buying from East Asia. This Weekly is being written in Moscow, where it is apparent that the Russian authorities are also committed to maintaining the value of the dollar against the rouble. Thus, "competitive devaluation", in the form of so many currencies attaching themselves firmly to the dollar, reigns supreme, except for the euro. As of this last week, it looks again that the euro is moving up by default, to the detriment of the euro zone economy. It might be Snow who is asking the Chinese and Japanese to revalue (only to be rebuffed), but it is the Europeans who are suffering the most from the artificial situation.


We keep wondering how long the Asians will keep up their currency interventions. One suggestion is that book closing in Japan at the end of September might be the moment when the Japanese give up their intervention policy. Moreover, one historical analysis we have seen suggests that, each time the BoJ has intervened massively in the forex market (as it has in recent weeks), it was a last gasp before finally letting the yen rise.


If the East Asians pull the plug and let the dollar fall further, then two phenomena not often seen together will happen, a weaker dollar and higher yields (because of the imported inflation). This is the stagflation scenario we painted some weeks back, and which remains an ever-present danger. The very fact that the world economy is in unknown territory of massive imbalances means that "resolution" may take an original form like the dollar and US bonds falling in parallel. This risk is why we cannot recommend lengthening of bond maturities until the situation is resolved. Whether the upward pressure on yields is due to real recovery, mere expectations of recovery, or extra Government borrowing can be debated, but the pressure is so substantial that even the "1% anchor" of the Fed rate cannot be taken for granted.


It is dawning on various commentators that the Federal Government accounts are presented in a way that no private organisation would dare, because it would be illegal. Provisions for future liabilities, notably on pensions and health care, are being totally ignored. Occasional light is shed on this theme, but, rather curiously, few seem to care about it. This week, for example, the publicly-funded Pension Benefit Guaranty Corporation issued an estimate that the under-funding of pensions previously estimated at $ 35 billion had risen to $ 80 billion.


Economic expansion of China is continuing at rates which beggar belief, while Japan's recovery is looking quite firm. The euro zone is vulnerable to its strong currency, but Germany is offering the interesting example of following US-style policies (internal deficit/tax cuts), but without the constraints of over-indebtedness and an external deficit. There is therefore hope that this "Keynesian" exit from recession may work. Schroeder still also needs success in his belated social reforms such as raising the age of retirement.


Since we wrote last week of emerging markets having, in many cases, emerged, spreads on Russia and Turkey have continued to tighten. We think the trend will continue. In contrast, spreads on corporate credits (which were overbought) have gone quite a bit wider to more realistic levels.


Italy has decided to join France by issuing inflation-linked bonds. In our view, the timing is questionable because rising rates and low inflation do not make them currently attractive. However, their time will come.


Recommended average maturity for bonds in each currency


Stay short until intermediate yields have met clear resistance, or broken out to new sustainable levels.

As of 30.07.03

Dr. Roy Damary
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