"Arguably the worst they’ve been in 60 years"

Three quick things this morning.

1) Putting aside the question of why on earth would Alistair Darling publicly predict the worst economic downturn for sixty years, the more interesting question is how does he come to that conclusion? No other forecaster is predicting such a disaster, and they all have exactly the same economic inputs as the Chancellor (he might get the official statistics a couple of days earlier than us, but it’s a fairly level playing field). So what does Darling have that we don’t have? What is his edge, his inside information? Well the only thing he will know that the market as a whole doesn’t know is the true state of the UK banking system, and just how fragile it is right now. We therefore need to be even more worried about the banks than before.

2) I talked recently about the state of the UK public finances, and how this might lead to a steepening of the UK yield curve. RBC Capital Markets have predicted that gilt issuance will rise to about £100 billion next year. So I’m bearish on long gilts – but here’s why I’m bearish on short gilts too. Overseas holdings of the gilt market have risen from around 17% back in 2000, to around 32% now. The marginal buyer of the gilt market is no longer the traditional pension fund or insurance company, it has become the Asian and Middle Eastern Central Banks. These Central Banks have been awash with liquidity as oil and commodity demand has rocketed, and the earnings have been recycled into western capital markets through purchases of government bonds. Whilst the pound remained strong, this was a good bet, but over the past year its trade weighted value has fallen by about 15%. If the overseas Central Banks decide that sterling isn’t a good store of wealth anymore it could leave a big hole to be filled in the government’s gilt issuance programme. Central Banks have a strong preference for short dated gilts (sub 5 years to maturity) and this is the area that would be hit by any fall off in demand. That’s one reason why our long duration, bullish gilt positioning is based at the ten year area of the yield curve.

3) Finally freight. I’ve long noticed a good relationship between the price of shipping goods around the globe, and the level of the gilt market. Freight pricing seems to anticipate the level of global economic demand more quickly than most other economic indicators. I look at the Baltic Dry Index (BDIY Index GP for Bloomberg users). The charts show that freight prices peaked in mid May this year. Since then the price has fallen by 43%. This chance in freight sentiment began about a month before the gilt market started to reverse from a bear trend to a bull trend, and yields fell from 5.25% to 4.45% now. If you believe in the predictive powers of freight pricing there more bad news ahead of the global economy – it continues to make new lows – but more good news for the gilt bulls.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Jim Leaviss

Job Title: CIO Public Fixed Income

Specialist Subjects: Macro economics and fixed interest asset allocation

Likes: Cycling, factory records, dim sum

Heroes: Brian Clough, Morrissey, Neil Armstrong

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