Bond
Outlook [by bridport
& cie, July 23rd 2003]
When it comes to wealth destruction, the recent fall in bond values
must rival any thing that happened to the stock market when the bubble
burst. For this contribution to mankind, investors can thank Alan
Greenspan for an operation we might call the "greenscam". It involved him
allowing investors to believe that the overwhelming risk was deflation and
that all means would be used, including the Fed buying long T-bonds, to
keep long-term yields low and support the "carry trade". Then Greenspan
pulled the rug and investors all fell down, taking off the carry trade. We
admit to being as much a victim of the greenscam as anyone else. At least
we all know whom never to trust again. |
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Beyond the half-truths, the inherent contradictions and unproven
optimism about the rolling "recovery in six months", our task is to weigh
up the likely developments in the US economy as the starting point to what
will happen there and elsewhere. Until last week we had "swallowed" the
greenscam line that the economy could only recover or deflate. Since
recovery with such a debt load looked impossible, we went along with
deflation being the more likely scenario, although, in fairness to
ourselves, we saw it as only a short-term phenomenon, as a weakening
dollar would offset deflationary pressures in time (we overestimated the
amount of time in making a "wild guess" of one year). |
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As of last week, because of a little publicised report that
producer prices were rising at a 4.8% annual rate, we began to think of
the third possibility: stagflation. Given our view that recovery is
impossible until the US imbalances have been corrected (view we hold
despite volatile stock market rallies), we see the debate as deflation vs.
stagflation. The latter is understood to mean slow growth (only slightly
above growth in working population), increasing unemployment, and rising
inflation and interest rates. |
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The arguments in favour of deflation (already rehearsed in this
Weekly) include excessive manufacturing capacity, global competition
(including competitive devaluations) and the impact of the Internet in
putting more price information in the hands of buyers. |
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In favour of stagflation are the weaker dollar and competition for
funds from Government indebtedness pushing up interest rates. Stagflation
is always "cost-push" not demand-pull. It can be because of runaway wage
demands as in the 1970's. This time, however, it looks like resulting from
rising costs of raw material and other inputs (whether priced in dollars
or not). Since June of 2002, when each measure was at a low,
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- consumer price
inflation has risen from 1% to 2% (but is now stable),
- producer prices
inflation has risen from -3% (!) to + 3% and is still rising
- commodity prices
have risen by about 14% (but are highly volatile).
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A major question for the outlook in this stagflation vs. deflation
competition is the future of the dollar. Bridgewater point out that, in
past periods of high twin deficits, the dollar fell but bonds did not.
They see the Fed producing "whatever liquidity is needed to shift some of
the downward pressure on bond and stock markets to the US dollar" - hoping
to attract foreign capital because the dollar is cheap (presumably with a
view to its appreciating again). Up to that point we agree with
Bridgewater's analysis, but we have to part company with them when they
continue to see the deflation model and falling yields as the most likely
scenario. Our view is towards the stagflation model, because of the force
of argument from the indices and because the dollar looks likely to fall
again. |
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Generally this is bad news for Europe, although beams (rather than
just "rays) of hope are shining in Germany, as Schroeder wins victory
after victory in his struggle for reform. |
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Despite our now leaning towards the stagflation model (yes, we
changed our minds over the last few weeks - but the facts changed, too!),
it would be inappropriate to recommend maturities other than those close
to the bond index. Yields overshot on the way down and may well do on the
way up. Besides the greenscam may not have run its course. New cash should
wait on the sidelines or be used to buy instruments to counter a further
rise in yields and inflation. |
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Recommended average maturity for bonds in each currency
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Be market neutral until the stagflation vs. deflation issue is
settled. |
Currency: |
USD
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GBP
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EUR
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CHF
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As of
02.07.03 |
2009
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2008
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2009
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2008
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