Bond Outlook [by bridport & cie, January 30th 2002]

Doubts about the reliability of US financial reporting, spreading on from Enron, through Tyco, the telecom companies and on to the auditors, the legal profession and bankers, appear to have shaken investors' faith in the valuation of the shares for which they are paying such high multiples. It is a sad reason indeed if it takes loss of faith in the system to bring share valuations to sensible levels. However, at least it can be said that market forces are forcing changes that neither politicians nor the watchdogs of transparency have taken on themselves.


Our view has long been that, even supposing transparency, PEs are far too high in view of the poor earnings outlook of corporations and unlikelihood of early traction, which, even when it does come, cannot lead to the spectacular earnings growth discounted in current share values. The double-dip view of the US economy has growing credence (it envisages a short-term pick-up as inventories are modestly rebuilt, but no serious pull through of final demand). The US consumers, as spendthrift as they are, cannot be totally confident in their shopping as their friends lose jobs and the sheer volume of their debt continues to grow. If the USA does pull out of the recession as quickly as financial markets and politicians seem to be thinking, it will have achieved a first. In no previous recession has private sector debt continued to grow right up to the recovery, i.e. downward adjustment of debt levels has always been a necessary condition for recovery, but is being studiously avoided this time.


Of course, the cheapness of credit partly explains the willingness and ability of both households and corporations to carry so much debt. However, consider this:


  • If spending is dependent on borrowing, and traction depends on spending, what happens when traction does occur, interest rates have to go up to control inflation and cost of debt financing massively increases?
  • Now add to this a US Government deficit, already obvious many months ago (as we have pointed out consistently in this publication), which has now been put on the table as formal, bi-partisan policy as the USA increases its defence spending and announces that it will be on a war footing for years to come. Does competition for funds between the Government and the private sector not inevitably lead to higher interest rates?


Some might point to Japan as an example of a country with a huge internal deficit and very low interest rates. However, the deflationary state of Japan, which even at our most pessimistic we would not see applying to the USA, implies high real interest rates in Japan even though nominal rates are so low.


The dilemma for American monetary policy is atrocious. Keep rates low to recover from the recession and generate enough profits and taxes to pay for increased expenditure, but also cope with the deficit itself pushing rates up and thereby killing the recovery. The crunch US policy makers will eventually be forced to face is, to many of us, a working through of what we have doubted deeply for more about two years, viz., the wisdom of not allowing the imbalances of the US economy to correct themselves under natural forces and the passage of time.


One of these imbalances is the excessively strong dollar. We have now put on the shelf our expectation of euro strengthening. (35-hour working weeks, and all the bureaucracy and social charges that go with such interference in sensible business practices, are just too strong a headwind.) Unfortunately, the very fact of the USA being on a war footing itself gives the dollar a refuge status, which in turn is just what the American economy, at least its manufacturing sector, does not need.


Our clients are reflecting the extreme uncertainty of the US, and therefore the world, recovery. The majority expect interest rates to go up, be it because of traction or a consequence of deficit financing. They are therefore going even shorter than our recommendations and moving into floaters and cash. Security and capital protection are the order of the day, with relatively few clients seeking yield. In addition, the implications of the gigantic losses that certain banks have incurred with Enron, plus suspicions that other "Enrons" are lurking, have led, quite rightly, to selling of bank bonds.


The incredibly slow motion performance of the Japanese collapse continues. The precipice of a falling yen proved too daunting, although we expect that route to return to the agenda after a few more months of non-action. The dilemma facing the Japanese Government (reform and cause huge suffering, don't reform and put off the reckoning) makes that facing the US Government trivial! It is, of course, far from trivial; these are interesting times, indeed.


Recommended average maturity for bonds in each currency
We have cut our recommended average maturities by a year across the board, and stress the defensiveness of FRNs in this period of uncertainty.

Over the period 15.08.01 to 21.11.01
As of 05.12.01
As of 30.01.02

Dr. Roy Damary

Currencies (by GNI)


A more optimistic outlook for the recovery of the US economy by different FED members, accompanied by better economic figures, and with even Chairman Greenspan becoming more optimistic, has helped the US currency to rally quite substantially. In this environment, it is hard think that the FED opt for further easing at today's FOMC meeting. Interest rates might be on hold for quite some time.


In Europe, M. Issing, Chief Economist of the ECB, says that the euro is undervalued. However, at the same, he admits that structural reforms on the fiscal and on the economic front are needed for the euro to appreciate.


EUR/USD: The market was taken by surprise and the move below 0.8730 created a huge wave of stop loss selling. Apart from short term corrections, the trend is clearly on the downside, with minor support at 0.8550, key support at 0.8480 and 0.8330 as the target. Only a rapid move above 0.8750 would abort this bearish scenario.


USD/CHF: Again the break at 1.6780 has been quite significant and, so long as we stay above this, it clearly speaks for a higher US unit. Next target and break through at 1.7250 followed by 1.75. Only a rapid move below 1.6750 would abolish this bullish outlook.


USD/JPY: After testing levels of around 135.00, the yen appears to be in a corrective mood in the short term. The break at 132.80 opens the door for a test of 131.50 and 130.30. Levels of around 130.00 should represent a good buying opportunity for medium and long-term prospects, with our first target of 136.90 followed by 140 still valid.


EUR/JPY: Here as well, the short-term correction of the yen went a bit further than expected. So long as the rate stays below 115.50, levels down to 113.00 should be used to buy EUR/JPY in expectation of continued medium and long-term JPY weakness.


USD/CAD: We are keeping our short position USD/CAD at 1.5955 with a S/L at 1.6300. Price objective is around 1.5650.


AUD/USD: The failure to break 0.5280 again puts the Aussie under pressure. A move below the psychological barrier of 0.5000 would be catastrophic and put into doubt all bullish forecasts made at the beginning of this year for a higher AUD. Then the price objective would be 0.4850.


GBP/CHF: Same comment: extreme volatility will remain in this cross. 2.3850 is acting as a pivotal point with a weekly close above looking for 2.4100 or below for 2.3550.



Current spot level
Current spot level
   Main         ©