Political risk lies front and centre for fixed income investors, says RWC’s Peter Allwright

Peter Allwright, co-head of the Absolute Return Bond and Currency Team at RWC, sees significant ongoing political risk to fixed income investors.

What can we say that is positive about Europe? Economic data across the region (including Germany) continues to deteriorate. The ECB continues to stand on the sidelines. Politicians continue to keep their heads buried in the sand.

Two key votes were passed in Greece last week: a structural reform package and the 2013 budget. However, this does not mean that Greece will be receiving the next tranche of bailout cash anytime soon. The Troika’s report, necessary before release of the bailout funds can be authorised, is not expected to be ready for the EU finance ministers’ meeting taking place this week. No decision on Greece is now expected until late November at the earliest. Isn’t Greece supposed to run out of money before then?

There is a €5bn Greek T-Bill redemption on Friday, but despite Greece reportedly not being able to raise enough cash to fund it, a fudge will doubtless be found. It appears that the core European powers do not want to force Greece out of the eurozone, but rather wait for Greece to decide to leave of its own volition. Another negative report from the Troika in Q1 could impose more austerity upon Greece, precipitating a new election, which would ultimately be a vote on whether to stay in the Eurozone or not.

In the short term, the ongoing situations in Greece and Spain point to volatility in EURUSD and for Bobls and Bunds to remain supported.

US

As the news came in that President Obama had been re-elected EURUSD rallied, USDJPY sold off and Treasuries rallied with flattening in the 2s10s part of the curve. This initial market response suggests renewed expectations of a highly dovish Fed, with more QE almost certain to be announced at the Fed’s December meeting. The market moves could also be interpreted as a symptom of worries that the Fiscal Cliff situation is more likely to drag on now than if either candidate had achieved a more decisive victory.

Indeed, the election result certainly failed to bring near term clarity on the Fiscal Cliff issue. If the US does go over the cliff then tax increases and spending cuts of over $600bn will take effect on the 1st January. President Obama and congressional leaders are expected to meet this Friday to discuss ways to avoid this scenario.

In the short-term it remains a very difficult political situation with both sides still digging in their heels; the longer it drags on, the more uncertainty it will create for both firms and consumers. Regardless of the outcome it seems likely that there will be some spending cuts and some tax increases which will crimp growth in Q1 and should be positive for Treasuries.

We must be careful with US economic data over the next few weeks and months as it is likely to be heavily affected by Hurricane Sandy, particularly initial jobless claims and retail sales.

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