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. |
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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. |
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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: |
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- 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?
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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. |
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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. |
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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. |
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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. |
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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. |
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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. |
Currency: |
USD |
GBP |
EUR |
CHF |
Over the period
15.08.01 to 21.11.01 |
2008 |
2006 |
2011 |
2011 |
As of
05.12.01 |
2006 |
2006 |
2006 |
2006 |
As of
30.01.02 |
2005 |
2005 |
2005 |
2005 |
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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. |
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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. |
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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. |
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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. |
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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. |
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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. |
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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. |
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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. |
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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. |
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USD/CHF |
EUR/USD |
EUR/CHF |
USD/JPY |
EUR/JPY |
Resistance/Breakout |
1.7250 |
0.8750 |
1.4880 |
133.10 |
115.50 |
Current spot
level |
1.6985 |
0.8655 |
1.4705 |
132.50 |
114.55 |
Support/Breakout |
1.6780 |
0.8480 |
1.4650 |
131.30 |
113.80 |
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AUD/USD |
NZD/USD |
USD/CAD |
GBP/USD |
XAU/USD |
Resistance/Breakout |
0.5280 |
0.4310 |
1.6210 |
1.4280 |
288.50 |
Current spot
level |
0.5060 |
0.4150 |
1.5875 |
1.4160 |
281.20 |
Support/Breakout |
0.5050 |
0.4050 |
1.5780 |
1.4050 |
278.50 |
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