Bond Outlook
[by bridport & cie, October 17th 2001]
Inflation, deflation or stagflation? We begin this with that
question this week, as, for fixed-income investors, it is at least as
important as any considerations on the stock market. |
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- The argument for
coming inflation is based on the move of the US Government to
deficit financing. For the moment official announcement speak only of
"less surplus". We find that difficult to accept: the tax rebates,
smaller tax base, greater military spending, subsidies to airlines and
to New York are bringing about a massive fiscal shift and we expect a
public deficit to make its appearance even in this fiscal year.
- The argument for
deflation is that profits are falling so fast, unemployment
increasing so much and even energy prices declining that expectations of
inflation may turn negative, creating a vicious circle à la Japonaise.
Moreover, deficit public financing need not create inflation if the
example of Japan is anything to go by.
- The argument for
stagflation is that the enormous amount of money available in the
US economy chases property and the high returns of government debt,
rather than investment aimed at production, while public deficit
financing pushes interest rates up. Whenever government debt competes
excessively with private investments, a problem arises (e.g. the West in
the 1970s, Russia in the 1990s).
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Whichever of these three pertain in a year or so's time, inflation
is undoubtedly off the agenda at least for the rest of this calendar year.
Oil prices are low and look like staying low, corporations have no room to
increase margins, shops cannot raise prices while they are encouraging the
customers to return, and the US Government has not yet started major sales
of long-term bonds. The current disinflation could conceivably turn into
deflation, but our judgement is that this risk is small, not least because
the socio-political structure of the USA is so totally different from
Japan's. The more likely income is inflation, with immediate reaction by
the Fed to raise short-term rates to head it off. At that point, somewhere
in 2002, Alan Greenspan's skills will have to be at their finest as he
steers between dampening inflation and causing
stagflation. |
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Thus we maintain our recommendation to remain long in bond
maturities but to be ready to jump short if and when our fears about US
deficit financing prove correct. |
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The argument that bonds now give such a low yield that the stock
market is attractive even at high PEs is currently proving more powerful
than the counter-argument that high stock prices and declining earnings do
not go together. The rally now underway is based on liquidity - lots of
cheap money looking for somewhere to go - rather than on economic
fundamentals. We remain sceptical that the recovery has staying power, as
we cling to the principle that long-term equity value has to be based on
solid fundamentals, i.e. strong and growing earnings. |
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Our first warnings about Argentina appeared in this weekly on
November 8th, 2000, and have been repeated throughout this
year. We expect a total unravelling of the Argentine economy in weeks or
months. The sooner the better, as the current situation with the fixed
peso/dollar parity is quite untenable. Although some contagion is
inevitable, the very fact that the Argentinean collapse is so much
expected allows us to hope it will be moderate. What with corporate
spreads still increasing and ratings being lowered (in the traditional
post facto way by the two major agencies!), it is exceedingly difficult to
find yield. In bond markets the flight to quality is still very much
underway, and contrasts strangely with the relatively strong stock
markets. We suppose that many investors are seeking to achieve a decent
return on a portfolio with the hope that the current stock market recovery
will last, but covering their downside by parking a large part of the ir
funds in ultra-safe bonds. |
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Recommended average maturity for bonds in each
currency Long positions should be maintained, but with close
attention to possible movement at the long
end. |
Currency: |
USD |
GBP |
EUR |
CHF |
Virtually
unchanged since 15.08.01 |
2008 |
2006 |
2011 |
2011 |
|
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Last week, the decision of the ECB to leave rates unchanged has not
helped the single currency to go further. Ernst Welteke, member of the ECB
Board, declared on Monday that the growth of the euro zone would be weaker
than expected before the 11th of September events, but that the ECB
monetary policy was not an obstacle to the economic growth. Nevertheless,
the finance ministers of the euro zone called upon the Frankfurt institute
to act rapidly and to follow the US example. |
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The greenback stayed rangy but volatile with the earnings season,
the American strike and the fear of new terrorist
attacks. |
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The Japanese Government said on Tuesday that it would compile a two
trillion yen supplementary budget this month to boost the economy and
implement structural reforms. |
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EUR/USD: The euro continued to move
sideways between 0.8950 and 0.9350. The status quo decision of the ECB
last week, plus a recovery of the US stocks markets, put some pressure on
the single currency and it seems that the exchange rate is looking to test
the bottom of the range. Medium term our view is still bullish but we
suggest acting carefully as volatility and uncertainty are still
high. |
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USD/CHF: Consolidation between
1.6175 and 1.6530. The dollar found some strength this week, but here
again the greenback could be put under pressure with the war in
Afghanistan and the risk of a terrorist counter-attack. |
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USD/JPY:
The exchange rate should be
supported this week at 120.45, we have a first objective at 122.50. An
exaggeration to 123.15 cannot be excluded. After that, the yen should
again strengthen. Only a weekly close above 123.00 could be a bull signal,
direction 125.00 |
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GBP/USD: Sterling should reach 1.4400
in a first step and a break of 1.4350 should announce 1.4120. A weekly
close above 1.4560 could oppose this bearish scenario. |
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USD/CAD: Good area support between
1.5550/15520. Next resistance is at 1.5700, before opening a 1.5820
target. |
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AUD/USD: Should be now supported at
0.5000 and limited by 0.5230 |
|
|
FOREX SPOT |
|
|
Supp./Res |
|
|
1.6530 |
USD/CHF |
1.6430 |
|
|
|
1.6170 |
|
|
0.9350 |
EUR/USD |
0.9032 |
|
|
|
0.8950 |
|
|
123.15 |
USD/JPY |
121.70 |
|
|
|
120.50 |
|
|
1.4560 |
GBP/USD |
1.4455 |
|
|
|
1.4350 |
|
|
1.5700 |
USD/CAD |
1.5640 |
|
|
|
1.5520 |
|
|
0.5230 |
AUD/USD |
0.5135 |
|
|
|
0.5000 |
|
|
111.00 |
EUR/JPY |
109.90 |
|
|
|
109.00 |
|
|
1.4920 |
EUR/CHF |
1.4845 |
|
|
|
1.4750 |
|
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OPTIONS VOLATILITIES |
|
1
M |
3
M |
USD/CHF |
11.35% |
11.50% |
EUR/USD |
10.60% |
11.05% |
USD/JPY |
9.85% |
9.90% |
GBP/USD |
8.00% |
8.55% |
|