Global Fixed Income Strategy- "It's Just Unpleasant"

I had the strange experience of taking part in a wellknown cooking competition recently (it's a hobby of mine) and one of the judges presiding over my "invention" managed to spit out both the food and the words "it's just unpleasant" after tasting it. Never a truer word has been spoken. But it's how I feel about this whole atmosphere surrounding the bond and currency markets right now: it's just unpleasant.

We don't have to go into here the well-documented problems in the corporate bond markets and everything that means for the contraction of credit supply going forwards, but equally importantly you have to be concerned by what is happening in the government bond markets: they are just too expensive for the long term even though you realise that yields have to decline further in this cycle.

The final straw for me came recently when President Putin of Russia announced that, due to western aggression, he was now prepared to reopen an arms race because western defence policy has the smell of oil and gas swirling around it.

Whatever the truth of that statement, the idea that we could enter a tit-for-tat rearmament programme comes at precisely the wrong time for the west, and the US in particular, (which is probably the point of it in the first place).

This is doubly true when you consider that Russia, like so many previously communist regimes, now has money while we have debt. In other words they can afford it, we can't. You only have to see the cost of engaging "The War on Terror" for the US to see the truth of this: annual military spending in the US now tops $674bn a year which is a massive nominal increase over the past eight years but, in real terms, only just brings it back to where it was under President Ronald Reagan (see illustration).

In other words it could go a lot further. If you think it through, tactically, this is a masterstroke by Putin: should the next president choose not to increase expenditure then a strategic advantage accrues to the Russians.

Should the next president choose to compete then the US will be plunged into further crippling expenditure which is engrained in the economy with all that follows from piling debt upon debt.

The reason to bring this up at this time is that we believe that the problems being piled upon the US are becoming very serious indeed and merely add to the atmosphere that surrounds the credit markets. What has really changed in the past couple of months is that swirling rumour and inexplicable market movements have been replaced by quantifiable losses and a series of confessional releases from financial institutions in the US and Europe. In essence, we now have some investible information rather than conjecture and supposition. And that information doesn't look very pretty.

Most estimates centre round about $400bn of losses accruing to the US financial system from sub-prime and credit losses going forwards. So far there has been an estimated $175bn announced so the bad news will continue for some time. At the same time it's possible to guess that about 300-400k workers still have to come out of the construction industry alone to return it back to preboom levels. So for the US Federal Reserve the next few months will provide no relief from what is generally being written up as a crisis of orders of magnitude greater than the busting of the dot.com bubble in 2000. Ben Bernanke is going to have every justification to cut interest rates further should the economy warrant it.

Having said all of this, the unremitting bad news from the financial system and economy hasn't stopped US long bond yields actually rising since the beginning of the year (see chart below) back to levels last seen in December. If it was the aim of the Federal Reserve to get long-term interest rates down (to help the process of resetting mortgage rates over the next six months) then the recent interest rate cuts have been a miserable failure. In fact it puts a question mark over how effective interest rates are in a situation like we are in.

Clearly, the markets are concerned about supply in the US: recent US Treasury auctions have swerved between disappointing to outright disastrous. With a $150bn tax give away due this May to be paid for and the notion that the budget deficit will expand if a recession kicks in, the steepening of the yield curve that has sent long yields higher has to be worrying as official policy actions are having no material effect.

So what's going to get long-term interest rates down in the near future? The passage of time will help of course: if it is true that we are in the midst of credit destruction, a debt-fuelled economy will naturally slow and with it some of those inflationary concerns. Also there is a window of opportunity in Q2 this year. Favourable rebasing effects will naturally drag headline consumer prices down around that time which may allow long bond yields to decline once more. In the meantime, I'm afraid it's going to be "just unpleasant".