Bond Outlook [by bridport & cie, August 20th 2003]

The subject we raised last week under "salvation from the East" is fundamental to understanding likely economic development. Data from the US Treasury show US Federal debt held by the "public" to be at $ 4 trillion (c.f. GDP of $ 10.8 trillion - not a bad ratio in its own right, it is the expansion of the debt which is problematic). Of the total, $1.3 trillion is held abroad, and 42% of this is owned by Japan and China (thanks to Merk Investments for these data); $442 billion by Japan and $ 122.5 billion by China. Both countries are practising a policy of buying up US Government securities to keep their currencies down. Another way of looking at it is to say that neither country can afford to let the dollar fall further, since they hold so many dollar-based assets. (See parallel with the old adage that if you owe a bank 1,000, you have a problem; if you owe it 1,000,000, the bank has a problem.)


The impact of the Chinese and Japanese policy decisions is to allow US profligacy to continue, but with attenuation of the two likely exits from a deficit situation, either a much weakened dollar or much higher interest rates, but, (as pointed out by Bridgewater - see our Weekly of July 23rd) not both together. Whether it is wise to let the USA continue to live way beyond its means can be much debated, but that is the effect. Which of the two "deficit exits" (higher yields or lower dollar) is likely to be attenuated the more by "salvation from the East"? We lean towards the latter, i.e. the dollar will maintain an unnatural strength, at least for as long as the US economy looks better than the European. That logic leads us to suppose that interest rates will rise further. That will stifle the modest growth in GDP, at which point the dollar will weaken. We can imagine a whole series of cycles coming in which 1) a weaker dollar helps GDP to expand, 2) interest rates and the dollar rise, 3) back to lower rates and weaker dollar -- a sort of bouncing back and forth between low dollar and high interest rates.


The key to breaking the cycle (letting the dollar go a lot lower and tolerating inflation, so that, despite history, higher rates pertain along with a weak dollar) lies in Chinese and Japanese hands. Until market forces overwhelm them that is; if the tide turns against the dollar not even these two central banks will stem it. The dreadful Mideast situation could be the trigger for further whipsawing.


A comment on the stock market. In 1999/2000 we learned a major lesson: we (correctly) recognised a bubble, but we failed to spot its bursting point. The latest rise in equity indices looks just like a bubble (PEs massively above their historical averages, an apparent suspense of "normal" economic laws, poor profitability with a squeeze on operating costs, upward pressure on input costs but little pricing power). Too much in common with 1999 for comfort, although then it was profitless revenue growth, now it is no revenue growth with profits from cost cutting. However, just when reality catches up with hope is beyond our ability to call.


US consumers have stopped refinancing their mortgages to maintain spending, but are besotted with housing as an investment. It looks like the "last chance to get onboard" before interest rates make housing too expensive for them. The same old story: spending by Government, spending on housing, but the chief guest for the recovery party is still missing -corporate investment.


Japanese and Chinese policies are not the only factors interfering with normal macro-economic analysis. The Fed's policy of "anchoring" the overnight rate, and the Treasury policy of not borrowing longer than ten years also disturb the picture. Both policies must be under market pressure. The yield curve is already so steep, that it is difficult to imagine it steepening further, despite our analysis above. Further steepening remains however such a risk that our recommendation for short maturities remains, while awaiting answers to the key question of which breaks again first, the dollar or interest rates.


Poor Europe. The best it can do is provide optimistic outlooks from business surveys as to future outlook. The fundamentals remain as dull as ever. The UK is staying outside the fray, with its service industries more than making up for lost employment in manufacturing. Our view of "salvation from the East" has a double meaning: demand from Japan and China to help the world, and, for Europe, investment opportunities, young, inexpensive workers and growing consumer demand from the new EU members.


Recommended average maturity for bonds in each currency


Stay short until the current uncertainties pass.

As of 30.07.03

Dr. Roy Damary
   Main         ©