Market Outlook June 2010: Strathclyde Associates

Published: Fri Jun 04 2010

Government bond markets have had a very traumatic month. The major markets have held fairly steady; but there have been dramatic falls in some of the minor markets, especially in Europe, after the decision by Standard and Poor’s to downgrade the level of Greek government debt to "junk" status.

The central banks are maintaining short-term interest rates at very low levels, and so the bond markets are continuing to receive some support. But this is being totally offset by the consequences of the massive fiscal deficits around the world that are placing enormous pressures on the bond markets.

Market Outlook June 2010: "Strathclyde Associates, Korea": The Greek situation remains in the eye of the storm, and has led to the decision to downgrade its debt to "junk" status despite a formal request for aid from the IMF and other member countries of the euro-zone to enable it to refinance its maturing debt and avoid a default. It is clear that the contagion is spreading to other members of the euro-zone, and so investors have continued to switch funds from the bond markets of the weaker countries and this has provided further support for the stronger markets. A significant development has been the strength of the US market.

Market Outlook June 2010: "Strathclyde Associates, Korea": However the prospects for all the other markets remain very uncertain. There will continue to be support from slow growth and low short-term rates; but there was always the risk that the fiscal policies that were introduced to counter the recession would produce problems in the bond markets, and there is now a risk that the markets may run out of

The Bank of International Settlements has recently warned "that the aftermath of the financial crisis is poised to bring the simmering fiscal problems in industrial economies to boiling-point", and that drastic measures will be needed to head off a compound interest rate spiral.

The latest developments in Greece have shown that the warning is fully justified. Sovereign debt defaults may still occur, and the single currency system in Europe may not survive in its present form.

Market Outlook June 2010: "Strathclyde Associates, Korea": Prospects for bond markets in mainland Europe are therefore particularly uncertain. Not all markets elsewhere will be similarly affected, and some may even continue to benefit from the problems in Europe; but higher bond yields everywhere seem to be unavoidable. The US bond markets appears to have achieved an enhanced "safe haven" status, and has improved slightly over the over the past month. The recovery in the economy is only proceeding at a very slow pace, and the Fed is clearly intending to keep short-term interest rates at "exceptionally low levels". But there are also serious funding problems in the market resulting from the huge fiscal deficit, and so it seems unlikely that the deficit can be adequately financed at present yield levels.

Market Outlook June 2010: "Strathclyde Associates, Korea": Prospects for bond markets in mainland Europe are... particularly uncertain. Not all markets elsewhere will be affected, and some may even continue to benefit from the problems in Europe. The latest evidence on the economic performance is
encouraging. Retail sales rebounded sharply in March; non-farm payrolls increased at the fastest monthly pace for three years in the same month; and both manufacturing and service sector output was higher.
Market Outlook June 2010: "Strathclyde Associates, Korea": The Fed is continuing to maintain a safe attitude. The statement after the latest meeting of its Open Market Committee is more encouraging, short-term interest rates have been left unchanged once again, and the unwinding of the stimulatory measures that were introduced to counter the recession is only proceeding at a very modest pace. Both the economic background and the policy of the Fed is continuing to support the market. However it is clear that the bond markets in mainland Europe face far more serious problems. The economic recovery is only proceeding at a slow pace, and short-term interest rates are likely to remain low; but the massive
fiscal deficits and their possible consequences are offsetting any possible benefits. Much now depends on developments in Greece. Despite a humiliating appeal to the IMF and to other member countries for help in financing its maturing debts, its bonds have been downgraded to "junk" status because of doubts about the rescue operation, and fears about the poor economic performance.

Market Outlook June 2010: "Strathclyde Associates, Korea": If the Greek authorities can implement the austerity measures that are being demanded before any loans are granted, then the threat of default on Greek bonds may be reduced, and there will be more time for other countries that are in similar difficulties, Portugal, Spain, Ireland, and even Italy, to take corrective action. But the situation clearly remains extremely uncertain, and this has persuaded investors to take evasive action, and to push yield spreads between stronger and weaker bonds to record levels. It was only after considerable hesitation that the Greek government made the formal request for aid. It was clearly concerned that the social unrest that has already occurred in the country would make it extremely difficult to implement even more extreme austerity measures; but in the end it had no choice. The request has produced a provisional agreement for the IMF to provide €15 billion in loans, and for the other member countries of the euro-zone to provide €30 billion, with the amounts varying according to the respective size of the lending country. The odds still seem to favour a successful completion of the loan agreement; but each country has still to obtain the necessary parliamentary approvals, and this is producing particular difficulties in Germany. In order to secure the necessary approvals, the German government is insisting
that the Greek government produced detailed proposals to meet the budget deficit reductions that are required for 2011 and 2012, as well as for the current year, before it can qualify for the loans. This is not likely to be an easy task; but all the parties are aware of the possible consequences of failure, and so some kind of "fudged" agreement seems inevitable. This may provide a short-term respite in the markets; but the overall prospects remain unattractive. The gilt edged market has remained relatively stable over the past month, despite the uncertain situation in the UK. There has been evidence of a further modest improvement in the economic background, and the Bank of England is holding short-term interest rates at low levels. But the UK also has very serious fiscal problems, and there are doubts whether the new government formed after the forthcoming general election will be able to cope adequately with those problems. It is possible therefore that it has been the disaster in the bond markets in mainland Europe that has been the main reason why the gilt edged market has performed so well. The economy is clearly continuing to benefit from the monetary and fiscal policies that were introduced to counter the recession; and so although unemployment remains high and the housing market recovery is very fragile, the recovery in activity is continuing.

Market Outlook June 2010: "Strathclyde Associates, Korea": The Office of National Statistics has recently estimated that growth in the first quarter of the year was only at a 0.2% rate; but it is likely that this estimate will be revised higher, and we expect that growth will be around the 2% level this year. However this is not likely to persuade the Bank of England to make any early moves to push short-term interest rates higher, and so the gilt edged market will continue to receive considerable support. The Japanese bond market has remained unchanged over the past month. The recovery from recession in and so there is political pressure for new policies to counter deflation, to monetise the government debt, and to push the exchange rate sharply lower to encourage the export effort. However the Japanese authorities have also been warned that they must prepare an aggressive plan to repair the fiscal position, or risk a downgrade in the country’s credit rating. Fitch Ratings has recently said, that "in the absence of sustained economic recovery and fiscal consolidation, government debt will continue to rise, placing downward pressure on sovereign credit and ratings over the medium term". This is the second time in less than six months that Fitch has expressed concern about the fiscal position; and Standard and Poor’s has also cut its outlook on Japan’s AA long-term rating to negative this year. So far these comments have been ignored, and Japanese institutional investors have continued to invest massive sums in the bond market. It is unlikely that this situation will change quickly, and so the Japanese government does not face the possibility of a sovereign debt default; but if no action is taken, and economic growth remains disappointing, it seems inevitable that the pressures must eventually push yields higher.
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