Looking ahead at the bond markets
We do not foresee much change in the areas most likely to
concentrate our thoughts during this second half of the year.
Europe will, of course, drive investor sentiment over the coming
weeks and remains the key tail-risk facing investors. The ECB's
extraordinary liquidity provision and collateral rules that allow
Greek bonds to be used as collateral - regardless of rating -
continues to be the lifeline for the peripheral countries and their
banking systems. Despite June's policy developments, long-term
solvency issues have not been properly addressed. A range of
initiatives are being debated by EU policymakers, each with their
own risks and unintended consequences. Market participants are
already testing the 'firewalls' installed by the authorities to
prevent widespread contagion and the window of opportunity to
satisfactorily resolve matters may start to close very quickly. As
we write, it will be a worry for EU officials to see the solvency
of Italy coming under the spotlight. Delaying a Greek default is
clearly the policy objective as this buys time for the European
banks to further improve their capital and funding positions. The
scenario is not dissimilar to the 1980s when a number of US
commercial banks held defaulting debt issued by Latin American
nations. This severely weakened the US banking system and it was
not until Treasury Secretary Nicholas Brady's bond restructuring
plan was introduced in 1989 that stability was restored. Brady
bonds, as the reissued securities became known, potentially offer a
blueprint for Europe and reports suggest this is one of the
solutions being debated.
Investor sentiment will also be driven by events in the US. We
need to keep our eye on two key issues. The first relates to
economic newsflow and verification, or otherwise, that the economy
is slowing to a dangerous level. Last month, the Federal Open
Market Committee (FOMC) revised down its forecasts for the economy
in 2011 and 2012. QE2 came to an end on June 30, and the Fed
Chairman, Ben Bernanke, has downplayed the likelihood of a third
wave of asset purchases, noting that deflation risks have receded.
We do not expect QE3 unless there is a significant worsening in the
outlook for growth. The second key issue relates to the need for
politicians in Washington to agree an extension to the Federal debt
ceiling. If this is not forthcoming, the government will not be
able to service pending coupons due on debt issued, and a technical
default rating may be applied by the major rating agencies. The
fact yields have not moved higher suggests markets are not taking
this issue too seriously, particularly with the travails in Europe
front and centre of most dealers' minds. This is understandable;
however, we believe complacency around this topic could be
dangerous. The credit rating of the US is a fundamental backdrop to
global markets and any question mark attached to this, no matter
how temporary, will cause yields to rise. Given the relative
weakness of its economy and poor public finances, the US can ill
afford an increase in its cost of borrowing.
The third issue likely to shape market confidence during the
second half of the year will be the ability of the Chinese
authorities to engineer a soft landing for their economy. They have
been tightening liquidity leading to a slowdown in the money supply
and credit, resulting in a deceleration of the economy. China's
capital spending and imports are bound to slow and this could have
a serious impact on global growth and, therefore, investor
sentiment. We recognise official published statistics have some
notoriety, however, our routines monitor key economic releases and
we will use these to assess the progress of Chinese monetary
policy.