Bond Outlook [by bridport & cie, August 27th 2003]

Feedback on our Weekly suggests that it is time to reiterate our basic statements of recent weeks, both to improve clarity and in recognition that financial markets are at some sort of hiatus (as they usually are at the end of the summer vacation time):


  • The US internal and external deficits are being financed largely by Japan and China's buying of Treasuries with a view to strengthening the USD and maintaining their exports. How long they are willing to do this is unknown, but the effect is to delay world economic rebalancing and to allow the USA to continue living beyond its means.
  • Massive indebtedness in every part of the US economy means that the recovery can only be mediocre. The impact of the end of mortgage refinancing is about to be felt.
  • The world economy remains stubbornly USA-centric despite stirrings of a domestic-based expansion in Asia. Japan is seeing savings at last being spent and China is turning bourgeois.
  • Euroland has problems of "one interest-rate fits all" and is singularly badly governed. Hopes of reforms in France are proving illusory, although Germany may yet succeed with its reforms, albeit inadequate. Germany is also likely to benefit most from the EU's expansion to the East.
  • The geo-political situation is becoming more and more anti-USA, with increasing costs to the US economy. The only way to reverse the trend is to solve the Palestinian-Israeli struggle.
  • The recent stock market recovery has taken valuations to extreme highs.
  • In economic terms, the UK is navigating quite nicely between the USA and Euroland, making joining of the euro a very distant perspective.


More specifically with regard to the fixed-income market:


  • The Fed and ECB have anchored the overnight rate at 1% and 2% respectively and are likely to hold them there for many months. Both rates are probably at their bottom, although the ECB may have some room to reduce a little further.
  • Government borrowing, high in Europe, enormous in the USA, is putting upward pressure on all yield curves. The USD curve is now the steepest and GBP the flattest, but all three are likely to steepen still more with Government deficit spending.
  • The US Treasury has said it will not issue bonds at long maturities, notably at 30 years. Yet this is such an obvious move (to take the pressure of the 3-10 year part of the yield curve) that a change in policy is a distinct possibility. Beware the effect on long-term yields.
  • The scope for a large rise in interest rates is limited because all major economies are so dependent on cheap money. Serious recoveries would be nipped in the bud by the associated rise in rates.
  • The spreads on corporates have come in significantly. They can come in further only if the recovery is stronger than we suppose.
  • Spreads on emerging markets are now very slim.


Daring to enter the field in which "everyone gets in wrong", foreign exchange, our view is that the recent strengthening of the dollar looks both temporary and dependent on the goodwill of Japan and China. We once spoke of $ 1.5 billion per working day of net capital inflow to the USA? Now, it is $ 2 billion!


Our recent recommendation to shorten reflects the above: yields are likely to move up a little more. Longer-term bonds are close to again being an attractive investment, but we cannot yet propose lengthening. When we do, it is likely to be the euro first.


Recommended average maturity for bonds in each currency


Stay short until intermediate yields have met clear resistance..

As of 30.07.03

Dr. Roy Damary
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