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International Bond Market Update

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Written by Peter Vutz, Senior Vice President,
International & Non-Dollar Portfolio Manager

The myth of developed and emerging economies decoupling from the U.S. business cycle was finally laid to rest in 2008 as the financial crisis hit the global economy with full force. Tighter credit and a trend of global deleveraging affected even the world's most profitable corporations. In the fourth quarter, even the mighty Toyota of Japan had to do the unthinkable and report its first operating loss in seven decades—an example of how otherwise-healthy companies have quickly been humbled by the worst economic crisis since the 1930s.

Access to bond dealers' balance sheets continued to come at a hefty premium through year-end, even in the case of sovereign issuers. Only markets like those of the United States, Germany, and Japan were able to withstand this trend. These countries carry the safe-haven label and have liquid markets with functioning futures exchanges that enable the dealer community to hedge their risk exposure.

The year was also marked by what might go down in history as one of the biggest monetary-policy blunders of all time. In an earlier report, we voiced our concern that a potentially catastrophic monetary-policy error could be made on this side of the Atlantic or the other—and we did not have to wait long. In July, the European Central Bank (ECB) decided to raise interest rates at a time when the European economy was already in dire need of a more accommodative policy. The prospect of looming disinflation, rather than inflation, should have been the ECB's priority, but that of course is the luxury of hindsight.

The Fed, on the other hand, has thrown in the proverbial kitchen sink by taking U.S. key interest rates down to levels even below those of the poster child of zero interest rate policy, the Bank of Japan (BOJ). The Bank of England (BOE) will continue its aggressive rate-cutting policy, and is likely to adapt to a policy of quantitative easing that mirrors that of the Fed. Other central banks from around the globe also still have plenty of fire power to cut rates. We believe that the ECB's statements suggesting a pause in the pace of further rate cuts are mere posturing; economic realities will set in quickly and will likely force the ECB to resume rate cuts during the first quarter of 2009. In order to adhere to their inflation-fighting mandate, however, we do not expect the hawks within the ECB to institute a zero interest rate policy.

This policy of easy money will be accompanied by a series of massive global (though regrettably uncoordinated) stimulus packages, which will result in an unheard-of debt burden for future generations. The printing presses are being warmed up around the globe as interest rates head toward zero in most developed countries. Unfortunately, the severity of the situation leaves little in the way of alternatives.

We believe that 2009 will present us with a new phenomenon: an unprecedented money grab. The ambitious economic stimulus package of the incoming presidential administration combined with rescue packages put in place by the outgoing one has created an insatiable appetite for capital. This comes at a time when governments around the world find themselves in a similar predicament, and will translate into a global government-issuance calendar of epic proportions.

In prior years, China struggled to keep its economy from overheating. Today, it is faced with a dramatic slowdown. Some pessimists are even predicting near-zero growth, compared with past periods of double-digit economic expansion. China is the largest foreign holder of U.S. Treasury and agency debt; and with its domestic economy in shambles, trade surpluses that used to be recycled back into U.S. financial instruments are rapidly evaporating. We are entering a period in which the Chinese government may need their excess reserves for further domestic stimulus packages of their own in order to avoid social unrest.

Meanwhile, the ten-year interest rate spread between Japanese government bonds and U.S. Treasuries has compressed to almost historically low levels. Japan is the second largest holder of U.S. Treasuries and agency debt, though the phenomenal performance of U.S. Treasuries has been largely diminished from a Japanese investor's point of view due to strengthening of the yen versus the U.S. dollar.

While we are not suggesting that foreign investors will initiate aggressive selling of U.S. debt instruments, it is conceivable that the safe-haven allure of the United States could lose some of its luster. Some investors might demand a higher return for their investments, while others will be tempted by the attractive alternatives within the non-dollar investment universe. For the time being, we will stick to our investment theme of allocating money to high-quality, liquid sovereign debt, but we are also keeping a keen eye on government-guaranteed financial paper. With so much bad news being discounted in the market, we are increasingly interested in the spread development of the highest-quality corporate paper. We expect most developed non-dollar debt instruments to outperform their U.S. dollar equivalents in the year to come.

Finally, during the fourth quarter, the U.S. dollar displayed extreme volatility by appreciating 10% versus the euro, only to give back the gains during the final month of the year. Though the dollar started strong again in 2009, the sustainability of this appreciation is questionable at best. The prerequisites for the continued strength of the dollar relative to other major currencies are twofold: economic prospects in the United States have to surprise to the upside, while economic prospects elsewhere must continue to deteriorate.

We expect that if the market is disappointed it will quickly shift its focus to the ballooning budget deficit in the United States, courtesy of the incoming administration seamlessly outdoing the free-spending ways of the outgoing one. This would undoubtedly take a toll on the value of the dollar. The days of a flight-to-quality translating into demand for U.S. dollars may come to an end if investors believe that the Bernanke Fed is willing to let the printing presses work overtime. By allowing the greenback to devalue, U.S. exporters would receive another much-needed stimulus from the new administration. In light of this, the dollar could soon resume its downward trend versus the euro and most other currencies. At the very least, we expect any further appreciation of the dollar to be capped.