BRIDPORT INVESTOR SERVICES WEEKLY
 

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.

 

  • 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).

 

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.

 

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.

 

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.

 

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.

 

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

Dr. Roy Damary


Currencies (by GNI)

 

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.

 

The greenback stayed rangy but volatile with the earnings season, the American strike and the fear of new terrorist attacks.

 

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.

 

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.

 

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.

 

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

 

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.

 

USD/CAD: Good area support between 1.5550/15520. Next resistance is at 1.5700, before opening a 1.5820 target.

 

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
 
 
 
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%
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