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Diverging bonds – which is right?

23 January 2009

The Technical Trader’s view:

The market has foiled the bulls for the moment, in the very short term, They (we!) wanted a break-up driven by the completed Continuation Triangle. But the pattern failed. Yet the market has demonstrated a powerful strength to get up as far as this – the push through the 123.64 2005 high was impressive. And twice the market has rejected attempts to fall back down through that level…. Compare that to the Gilts

This is an altogether weaker contract. The failures both to penetrate the long-term Pivotal High and to sustain the bull trend above major support (120.75) contrast powerfully with the doughty bund. The Bunds and the Gilt have diverged, certainly. But relative performance is one thing. More interesting is which of these markets is pointing in the correct future direction? (Or does anyone suppose they will go in opposite directions? We think not!) Earlier this week we wondered whether the US TNote would resolve the uncertainty. But that hasn’t happened yet. Increasingly, we think that the Gilt is ahead of the game that other markets may begin to focus on in due course…

The Macro Trader’s view:

As Governments globally pump billions into their economies in an attempt to stave off what increasingly looks like the worst recession since WW11, the recent rally in bonds has paused. The first signs of investor hesitation occurred a couple of weeks ago when the German government failed to cover a Euro 6.0B Bund issue, which raised eyebrows but didn’t end the rally.

But now, as governments are forced to pump yet more money into their Banks, with calls in the UK for wage subsidies to contain unemployment and a rescue bid for French car makers, the bond rally looks ripe for a correction.

In the UK the situation looks even more serious. Government debt already forecast to soar as a result of the November budget, now looks like spiralling out of control. The EU issued a damming report on the UK economy and the outlook for government borrowing, expecting the Budget deficit to hit 8.8% of GDP and the debt to GDP ratio to exceed 70%.

This is due to the economy contracting by more than the government forecast. In the November Budget, the Chancellor forecast growth for 2009 0f between -0.75% to – 1.25%. That now looks woefully inaccurate.

Unemployment is rising fast, house repossessions are soaring and retailers are going bust. Were it not for the government pumping in vast amounts of taxpayers money, the UK Banking industry would now be a mere shadow of its former self.

But even with government financial support, UK Bank shares continue to collapse on the stock market, leading to calls for the once giants of the Banking world; RBS and Lloyds Banking Group, to be nationalised.

Herein lies the Gilt’s weakness.

The UK government’s attempts to save the Banking industry and efforts to protect against a recession that will hit anyway have at a stroke put the UK’S AAA sovereign rating at risk.

In the last few days the Pound has sold off hard as currency traders have begun pricing in the risk of a sovereign downgrade, which would not only make it more difficult for the UK government to fund its deficit, but also make it more expensive and thereby make the fiscal position even worse.

While the Bund has corrected over recent days, the Gilt has come under much greater selling pressure, and the announcement on Monday that the Bank of England will receive new powers to expand the money supply by buying corporate bonds/ print money, has failed to offer the Gilt market any support at all, in fact the opposite has occurred as traders/investors are increasingly losing confidence in this governments economic competence.
In this environment we expect to see the Gilt weaken further.
The Bund is not currently afflicted by these concerns to the same extent:
- Core Euro zone countries are considered relatively sound,
- Even though peripheral Euro zone economies have caused the IMF to place a question mark over their fiscal sustainability.

Whether or not the Bund is able to resume its rally, and currently the Macro Trader thinks it will, we see the Gilt seriously under-performing with the yield spread between the Gilt and Bund widening in the Bunds favour.

Using fiscal pump priming to stabilise a weakening economy is ok, but this government has not only thrown caution to the wind, but their sense of rationality and proportion too.

Mark Sturdy, John Lewis
Seven Days Ahead

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