Bond Outlook [by bridport & cie, January 15th 2003]

"Tooth Fairy economics" (we must thank the FT for the concept): if you still believe in the Tooth Fairy, you can believe that lower tax rates and more government spending will so increase economic activity that tax receipts go up and close the deficit. At least some American politicians, even among Republicans, are conscious that increasing internal deficits do bring with them problems of competing for funds. The Return of the Twin Deficits: 2003 now looks like a $ 350 billion internal deficit and a $ 550 billion external deficit. Most of us believe in the Tooth Fairy till all our milk teeth have gone. The parallel with the Cowboy's politico-economics is that if enough people still believe in it by the end of his first term, all will be well.


Still, the removal of double taxation on dividends is sound - not very original, but a good idea. We rather expect that enough people will catch on to how illogical it would be to treat dividends differently from interest that, in the end, the final version will be to make dividends tax deductible for corporations, just like interest, and leave the tax burden on the recipients.


Bringing dividends back into favour will alter strategic thinking in the USA. Investments that generate real cash flow will be preferred over "paper deals" focusing on share price rather than profits and cash. It will be like a return to basics: old ideals like satisfying demand, against competition, and at a profit. Stocks of dividend-orientated corporations will benefit, and there will be pressure on those who pay no dividends to change their ways. Watch Microsoft as a bell-weather to see if it will share some of its cash hoard with shareholders.


One of our pet theories is that, because Europe did not go so overboard in the dotcom bubble as the USA, it needs less time to renew growth. Without Germany, the theory could even prove correct. France and the UK have both recorded manufacturing increases these last few weeks. Let us hope that they are not short lived. In Germany, some say that Schroeder is showing a few signs of courage. He avoided the public sector strike, at a price, but not a terribly high one. Verdi (the trade union) is now turning its attention to the hapless Lufthansa. Any temptation towards Schadenfreude non-Germans might have had has long gone. Europe, indeed the world, needs a strong German economy.


It needs a strong Japanese one, too, but we laid that hope aside many years ago. Could we be at the beginning of a sort of handing-on of the baton in Asia, from Japan to China? Growth rates in China are now like Japan's twenty years ago: a 15% increase in industrial production in 2002, based on foreign investment and local entrepreneurship. True, the state enterprises are a dead weight and the banks are carrying undeclared bad debts, but China is becoming a major economic force, with one of its impacts being to put downward price pressure on manufactured goods in all the developed economies.


The ECB has room to lower interest rates and will do so, gradually, during the year. This expectation has made us seriously consider lengthening our recommended euro maturities, but it is not yet the moment. In the USA, there may be room for another 25 bp cut, but the real action will be at the long end of the yield curve. If the Administration follows the logic of its economic policy, it will buy back long-term Treasuries to flatten the yield curve. That will prove tricky when the Government's own borrowing needs are ballooning, but it might work for the year or two required by the election cycle. Maybe, the Americans will sell gold, or persuade the Japanese to buy more Treasuries; that would help weaken the yen and help cover the US internal deficit. Alas, all such moves are just short-term fixes.


Spreads on both corporate and emerging market bonds have been coming in, although our own clients are generally moving against the trend and seeking to lower risk exposure. This may be due to the threatened war with Iraq. Its likely economic impact will follow the same path as American budget and monetary policy: short-term gain (like a stock market rally), long-term pain (like even bigger deficits to put right).


The attraction of the Norwegian Crown as a fringe currency to the EUR may be shifting to the Danish Crown. Sterling, unsurprisingly, is in its usual position of moving with the dollar, but at an attenuated rate. Its demise in favour of the euro looks very unlikely so long as Germany remains in the doldrums and euro zone unemployment so high.


Recommended average maturity for bonds in each currency


No move yet from an average of five years, although we are watching the euro situation carefully.

As of 8.01.03

Dr. Roy Damary

Currencies (by GNI)
Despite the increase in output of 1.5 million barrels per day decided by OPEC, the oil price remains firm. The US and the UK are increasing the pressure on Iraq. In Japan, Mizoguchi replaced Kuroda and is now directing future possible currency interventions. We also expect the announcement by the Japanese Government of the new chief of the BoJ. Apart from profit taking on short dollar positions, the sentiment remains clearly negative towards the US unit, and the strategy remains to sell on any dollar rally. Things might possibly become clearer after the end of this month.

EUR/USD: The euro managed to close above 1.0500 and has reached levels around 1.0600 so far. Only a weekly close above 1.0650 would speak for further gains in the short term. Good support at 1.0480 and 1.0430, followed by 1.0350.


USD/CHF: The low so far has been at 1.3780 and only a weekly close below 1.3750 would put further pressure on the dollar. Upside resistance is at 1.3950, 1.4010 and 1.4050, followed by 1.4130.


USD/JPY: We have been stopped on our long USD/JPY position (established at 118.90) at 117.78 (a loss of 112 pts). A close below 117.80 would put on further pressure in the direction of 117.30, 116.80 and 116.30, followed by 115.50. Upside resistance is at 118.80, 119.30, 119.80 and 120.30.


EUR/JPY: There was a slight exaggeration above 126.00, followed fairly quickly by slight easing to below 125.--. Strong support comes in at 123.80 and123.50. Resistance is at 124.50, 125.10 and 125.50.


USD/CAD: The Canadian dollar, like the Aussie and the Kiwi, has benefited from strong investor demand and was able to take out strong support at 1.5480, a level which is now providing very strong resistance. Support comes in at 1.5350, and only a weekly close below would strengthen the CAD further, direction 1.5150.


AUD/USD: Key support is now coming in at 0.5780 followed by 0.5730. The trend remains clearly orientated to the upside, with 0.5850, 0.5880 and 0.5930 as the next price objectives.



Current spot level


Current spot level
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