Manic depressive
Global bonds and currencies

If it doesn't start with a trillion, it doesn't count. The general reaction to the recent G20 announcement is that the headline policy measures amounted simply to a rehash of existing plans. There was one area that was new, and that was the U.S.$250 billion increased issuance of special drawing rights (SDR) by the International Monetary Fund. This is another form of 'quantitative easing' (QE), by which the IMF creates SDRs and apportions them to the IMF voting members, who can convert them into U.S. dollars, yen, euros and sterling. The increased funding for the IMF has largely been announced before, but it does remove concerns about whether the IMF has suffi cient resources. The fact that the Chinese have not committed much suggests they may be holding out for a broader reform of the IMF voting system.

The other recent announcements about QE by the UK and the U.S. have added to other fundamental areas of support for global bonds such as steep yield curves and zero cash rates; but there are many opposing forces affecting currency and bond markets at present. It seems that the mood of the markets changes daily from optimistic to pessimistic. This is a significant change from the first two months of the year when everyone was falling over themselves to be depressed about the outlook for the world economy and worrying about the creditworthiness of governments. We seem to be slipping into one of those phases in which the optimists are gradually coming to the fore and outweighing the doomsayers. We have had economic data that has moved from extremely bad (depression-like) to just bad (normal recession-like). As we move through this phase, QE will stop government bond yields rising, but spreads will narrow and we can take advantage of this narrowing by holding high-quality issues, inflation-linked securities and peripheral government bonds which are trading at relatively high yields.

Currencies will continue to be a much more fragmented story and could be helpful in adding value. The global economic slowdown and the credit crunch boosted safehaven currencies (such as the yen and the Swiss franc) to levels that are affecting economic prospects materially.

The U.S. and UK authorities have resorted to printing money. Some say such action is negative for a currency, but it need not be so for the dollar or sterling if it works and if, as a result of it, the U.S. and UK economies come out of this mess earlier than others. The Europeans have not yet resorted to debasement via QE and some argue that this should make the euro a 'winner'. However, the European economy is crying out for help and a weakening central Europe is on the verge of dragging parts of the euro bloc down with it. The 'ugly contest' continues. The euro has traded in a range against the U.S. dollar since October, but the yen is drifting lower against both the euro and the dollar. Our strategy is to be underweight in all three currencies and to seek value elsewhere.

At times like this, you have to stick to long-term themes. There are two basic assumptions one can make. First, it takes longer than expected to recover from a global economic slowdown of this magnitude and it will require a prolonged period of monetary and fiscal stimulus to offset the scale of deleveraging that is occurring in the global financial system. Unemployment will remain a significant factor and interest rates will have to be kept low.

Countries with the biggest debt overhang are those that are generally spending more time on monetary initiatives, and their economies tend to be more responsive to leverage than others. They need to reach a hard-to-gauge 'tipping point', at which there is enough public debt to offset the scrapping/ downgrading of private sector debt but not so much debt that governments' own credit standing is debased (which would push up the very yields that authorities are trying to bring down). This may sound simple, but it is not.

U.S. and UK authorities are in the process of trying to identify this tipping point. They are seeking to create stability for private sector debt by scrapping mark-to-market rules (U.S.) and to put in place support for toxic assets through government insurance schemes and purchase schemes. QE helps to offset the large globules of public debt being created by introducing a new buyer (central banks) to the market. The best guess is that we will reach a tipping point before the Europeans set out their 'weights and measures'. One of our fears is that the weighing machine in Japan has been left out in the rain for too long and that Japan has run out of weights. On balance, when looking at the major currency crosses (the yen, the euro and the U.S. dollar), it is the U.S. dollar that still comes out as the marginal favorite.

The second assumption is that, if you assume that the world does recover from this mess, those that have resorted to printing money but that fail adequately to remove the stimulus in time (which they will) will be left with an inflation problem. Inflation will erode quickly the value of any currency and lead to a flight to new 'safe-havens' (such as the euro and currencies in parts of Asia). While we wait for this currency dichotomy to be played out, we will sit it out in currencies that look cheap and/or are backed by large reserves. Looking at the developed markets, it is sometimes hard to find many currencies that fit these criteria. We have chosen to focus on currencies which are generally cheaper than they were this time last year and which have 'survivability' characteristics.

To respond to this split-personality environment, we will maintain core bond positions in markets supported by QE. At the same time, we will maintain exposure to emerging-market bonds and their currencies and obtain diversification through other areas such as quasi-government bonds and inflation-linked securities.