Bond Outlook [by bridport & cie, August 13th 2003]

Salvation from the East? If Japan is recovering based on household consumption and private investment (as distinct from "just" exports), then indeed there is room for optimism for the world as a whole. If China will but open the gates to domestic consumption, then the world could at last break its dependency on the over-spent USA for economic growth. Even India is joining in an Asian economic expansion based on domestic consumption.


Salvation for the USA, or at least a lifeline, is being provided to the USA directly by Japan as the US Treasury expands its borrowing programme to finance the fast-approaching $ 500 billion federal deficit. The Japanese Government, presumably giving orders to the BoJ, has decided to be the lender of last resort to the USA by being the main purchaser of Treasury issues, particularly at ten years. This action is motivated primarily by a policy of keeping the yen down against the dollar, but has the secondary effect of weakening the impact of additional Treasury borrowing on the USD yield curve. The Japanese action is slowing the move to a lower dollar and higher rates that we are still expecting. For just how long the Japanese can play the game remains to be seen. Our sense is that their action is all part of putting off the inevitable.


Every quarter the US Treasury will be coming to market to borrow in the order of $ 100 billion, focusing on the 3-10 year maturities, while the Fed anchors the overnight rate at 1%. The Treasury should, of course, be out at 30 years, but will resist that sensible move for as long as possible lest they look too foolish after announcing that there would be no more very long issues. On the supposition that investors are not being treated to another "greenscam" on the question of 30-year bonds, all the upward pressure of Administration borrowing on the yield curve will be over 3-10 years. It is therefore this range of maturities that fixed-income investors should avoid (Japanese intervention or not). This view is being espoused by our clients, who are tending to agree with our recommendation of a three-year average maturity or, are going out way beyond ten years, especially in CHF and EUR.


Euroland yields are rising with US yields; a decoupling can take place only if the dollar eventually enters a period of further decline. Till then, staying short in all currencies except for the odd component of "very long" makes sense. Yes, we admit that this is an uncourageous "wait and see" approach, but caution rules with so much uncertainty and the pain still fresh of falling for the first greenscam in June.


The arrival in the EU of ten low-wage countries means a continuation of the trend to move manufacturing eastwards. That will be painful for employment in Western Europe, but at least it will provide an alternative to Chinese manufacturing and Indian service outsourcing, with the consumer wealth gradually created in the new member countries staying part of the "domestic" market. German industry, with its focus on capital equipment and its geographical nearness to the new members, should do quite well. This allows us to maintain our modest optimism that Germany can return to its role of economic motor. The real test, however, will be whether domestic consumption also increases in the way it is in Japan.


The example of German unification is not very encouraging for the EU outlook with new, mainly ex-communist member countries. However, the East European currencies, as they join the euro within the decade, will not be artificially overvalued as was the Ostmark. Neither will there be quite the massive shift of fiscal resources from West to East. So, overall, optimism about the expanded EU is in order.


Looking beyond the current uncertainties and the implied connivance between the US Treasury, the Fed and the Bank of Japan, we see a scenario of rising interest rates in USA (independent of how strong or weak the recovery) and of rates in Europe rising more slowly. That may mean that we eventually recommend lengthening in European currencies before the dollar, but now, with the Bund still closely coupled to the T-bond, is not the moment.


The supposed Japanese recovery may offer fixed-income investors an opportunity in convertibles.


Recommended average maturity for bonds in each currency


Stay short until the current uncertainties pass.

As of 30.07.03

Dr. Roy Damary
   Main         ©