Bond Outlook [by bridport & cie, September 24th 2003]

We were looking for an end-summer breakout, and seem to have found it in the G7 meeting last week admitting that the world economic imbalances are unsustainable and rebalancing demands a weaker dollar and stronger Asian currencies. The strengthening of the yen is a very positive development, not least because it takes some of the pressure off the euro, which is getting too strong for its own good. Japan has two reasons to back off its "cheap yen" policy: one is that it is hard to be a member of the G7 and totally ignore the other six and the IMF; the other is that capital movements in Japan are not entirely controlled by the Bank of Japan (the private sector and foreigners have their word to say!).


The adjustment of three legs of exchange rates USD/EUR/YEN is a very positive phenomenon, but real rebalancing requires a fourth leg: RMB (China). While the West can "get at" Japan, China is a far more difficult case. The Renminbi is not freely convertible and the Bank of China really does control the exchange in an almost absolute sense. There is pressure on China, partly effective on the Hong Kong dollar, but even that currency is far from floating, while the Bank of China just obeys its recalcitrant Government. Nonetheless, the G7 meeting is likely to be looked back on as the start of serious currency realignment. The very weakness of the G7 statement is possibly part of the machinations to let the dollar decline gently, for "no one" wants a drastic fall.


G7 gives us a provisional answer as to when and how the dollar will decline (second leg starting now, and in a fairly controlled way). The next question might be "to what point", but we must back off that one. A question that is more possible to answer concerns interest rates. In principle, fewer purchases of US bonds by foreign Central Banks will mean that the US Treasury has to offer a higher interest rate to attract buyers. Yet the adjustment in medium-term rates has already happened, as it were, in anticipation of a weaker dollar. Medium-term rates are therefore in a holding pattern with no break out from the trading range. While deficit financing puts upward pressure on rates, doubts about the US recovery and the stock market rally apply downward pressure. Our own long-held argument that a robust recovery is held back by over-indebtedness remains. Any "serious" recovery will increase rates, dampening growth to a mediocre level - not enough, by the way, to solve the jobless problem in the USA.


Might there be a third force acting on interest rates in the form of the Fed buying medium-term Treasuries, despite denial of this last July? It is all very possible, and leaves us in a difficult situation when it comes to foreseeing the movement of the yield curve. On balance, we believe dollar medium-term rates must rise even as the dollar declines. In fact, we see rising rates as one of the means of slowing the decline of the dollar. This leads us to repeat our conclusion of the last four weeks, viz., that, apart from short-term trading opportunities, significant lengthening of dollar durations should be delayed.


Likewise for the euro, although the probability in Euroland for lower rates across the board is higher than in the USA. A rising currency, especially when the rise is unwelcome, should encourage lower rates. Trichet may be supposed to be less obsessed about a 2% inflation ceiling than Duisenberg, and he has some room to lower the money-market rate. That is a very different situation from the Fed's, who must be finding it difficult to maintain the 1% anchor in place when there is such upward pressure on bond yields. Thus we are still waiting, expecting our next portfolio recommendation to be to lengthen in euros.


Data on foreign purchases of US bonds - the most important single determinant of the dollar's strength - show the massive expansion of Chinese and Japanese purchases. Less noticed is that the UK is the largest single foreign purchaser of US bonds ($187 billion over the last 12 months, vs. 109 Japan and 73 China -source: Bridgewater). This largely reflects the UK's involvement in fund management and a historical orientation to the USA, but may reflect a little encouragement by the Government to keep Sterling closer to the dollar than to the euro.


Spreads in the emerging markets for Brazil, Venezuela and Turkey have narrowed substantially, suggesting that profit taking should be considered, as investors are doing in Russia.


Recommended average maturity for bonds in each currency


We are still looking to lengthen in euros but not dollars.

As of 30.07.03

Dr. Roy Damary
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