Bond Vigilantes

The credit rating agency Moodys this week released the initial output from its widespread review of the banking sector. Whilst the expected outcome had been for a number of banks to benefit from upgrades to their ratings, the market was taken aback by the initial set of rating revisions. The process is set to take place over seven weeks and will cover approximately 1,000 deposit taking banks in over 90 countries. A link to the report is here (free registration is required).

The initial release on the 26th February saw banks in the Nordic region receive upgrades by as many as four or five notches, some to Moodys' highest rating of Aaa, ranking them alongside sovereign bond issuers such as the UK, Germany and the US. Moodys' rationale is predicated upon its new Joint Default Analysis (JDA) approach. Moodys claim that "banks will receive national government support, as well as other major forms of external support such as parental support and support from regional and local governments and cooperative and mutualist groups" which have led to the rethink.

The reaction to the upgrades has been twofold. Firstly as you'd expect, those banks so far benefiting from upgrades have seen the value of their bonds rise in response. Secondly, Moodys have come in for a great deal of criticism. Many investors have questioned the lack of transparency in the new process. It had previously been believed that Moodys were already factoring in state and/or parental support. Investors have questioned for example whether a country such as Iceland (with a population similar in size to Hull, and an economy based around cod) has the ability to support banks which has liabilities three times the nation's Gross Domestic Product. The new process has also made it far more difficult to distinguish between banks on a credit fundamental basis given the added parental/governmental factor.

The ongoing process is expected to lead to further upgrades, further confusion and no doubt further criticism. One disgruntled bond trader has created this clip. Warning - may only be funny to bond geeks.

Private Equity (PE) funds have been in the news for all sorts of reasons recently. On the one hand these ‘locusts’ are under attack from unions, but on the other they are praised by the head of the CBI. While there may be changes to their regulation or disclosure requirements, one thing is certain: the amount of money they have raised and continue to raise will make them a significant influence on equity and corporate bond markets over the next few years.

PE funds raised $432bn last year globally, according to Private Equity Intelligence, which gives them firepower of around $2 trillion if they used 4 times as much debt to buy companies. And estimates suggest they may raise more in 2007, possibly $500bn. We should expect more Leveraged Buy-Outs (LBOs) in 2007, after all 8 out of the 10 largest LBOs of all time happened in 2006 after less money was raised in 2005.

What does this mean for corporate bond investors? Well bondholders of potential targets, likely to be investment grade, should make sure they are protected with covenants so they can get their money back. There are few places to hide when even Home Depot in the US is talked about as a target. High Yield investors are likely to see more issuance to fund the LBOs but should make sure that the PE fund hasn’t overpaid (multiples are rising as shareholders become less willing to be bought out cheaply).

But the more significant effect may be for corporate Europe to take on more debt and fall down the credit spectrum. Companies such as Portugal Telecom, currently being courted by Sonaecom, are offering special dividends funded by debt to fend off a takeover and so you could see their ratings fall to junk even if they are not taken over. This would bring the ratings of European companies more in line with US companies that have typically had more debt. Maybe one of the reasons for European companies having less debt than their US counterparts was a less established capital market for junk rated companies in Europe, but that fear should have eroded with the maturity of both the European High Yield and Leveraged Loan markets that are more able to finance lower rated companies.

Not since I began working in the City in the mid 1980s can I remember seeing an economic data release come out so many billions higher than market expectations. Yesterday morning, it was announced that so-called M4 lending, which is the amount of money in loans that is pumped out by banks, jumped to a new record of £31.7bn in January. A survey of economists had predicted a figure of £11.8bn - that's a difference of £19.9bn! To put this figure in perspective, M4 lending in January was larger than in the whole of 1994. Yesterday the Bank of England also announced that M4 money supply growth, which is the broadest measure of UK money supply including notes and coin in circulation and bank deposits, rose 13% from a year earlier, ahead of the 12.7% survey prediction and only slightly below the 16 year high of 14.4% that was reached last autumn.

Gilts were marginally damaged by these figures, but why did the bond market not sell off by more? Two answers spring to mind - firstly, complacency; and secondly, the focus on money supply is nowhere near as strong now as it was a couple of decades ago, when the government used to target the money supply in an effort to control inflation.

There is no doubt that in the long run, increases in money growth are more often than not associated with increases in inflation. One of Milton Friedman's two most famous quotes was that "inflation is always and everywhere a monetary phenomenon" (the other quote being "there is no such a thing as a free lunch", which is something I don't entirely agree with!).

The Bank of England recognises this link between money supply and inflation, since contained within the last inflation report were the words "strong money growth may be associated with greater spending on goods and services, or upward pressure on asset prices, posing an upside risk to inflation. To the extent that people recognise this, strong money growth may also prompt them to raise their expectations of future inflation".

But the extent to which money supply growth causes inflation is the subject of an economic debate that has been raging for centuries. I don't want to go into this here, although it is definitely worth mentioning that the money supply clearly plays a role in Mervyn King's mind. In "No inflation, no money - the role of money in the economy" , a paper he wrote while Deputy Governor of the Bank of England in 2002, he concludes:
"My own belief is that the absence of money in the standard models which economists use will cause problems in future, and that there will be profitable developments from future research into the way in which money affects risk premia and economic behaviour more generally. Money, I conjecture, will regain an important place in the conversation of economists."

If the Governor of the Bank of England cares about money lending and money supply growth, then so do I. Yesterday's data releases reinforce my view that the Bank of England will have to hike rates twice more, and possibly by more than that.

US sub-prime mortgages, those mortgages targeted at consumers with impaired or low credit ratings, have been the talk of the bond markets last week. The sub-prime market has grown significantly in the last few years spurred on by favourable circumstances including a falling unemployment rate, generally rising house prices and ever more accommodative lending practices. That willingness amongst lenders to re-finance existing sub-prime mortgages, often on increasingly favourable terms, meant that even those homeowners who found themselves in real financial difficulty were often able to re-finance. However, that situation has now changed. With existing and new home sales down significantly year on year in 2006 rapid house price appreciation is no longer a source of ready funds for distressed homeowners. Given the general wider strength of the US economy the increase in delinquencies to levels not seen since mid 2003 is a cause for concern. The most recent data has sub-prime loan delinquencies (loans 60 or more days past due or in foreclosure) running at around 12.5%.

Whilst the uptick in delinquencies has been only too apparent in the ABX indices (the riskiest portion rated by Moodys & S&P fell from a price of 96 at the start of the year to 87 on the 15th February, these indices essentially reference sub-prime mortgage debt) the wider impact on the bond markets has been limited. The reason for this is the belief that the issues that are currently plaguing the sub-prime mortgage market are not a symptom of a wider consumer credit problem, that growth remains fairly strong and that the banks involved can fairly comfortably swallow the associated losses. True, delinquency rates on other types of consumer lending are low by historical standards and the larger sub-prime lenders such as Wells Fargo, HSBC, New Century & Countrywide can afford to swallow the associated losses (as you'd expect their equity performance has suffered) concerns remain. Principally I believe there is an obvious danger in assuming that the liquidity this market has enjoyed will be an ever present. Sub-prime mortgages typically enjoy a 'low' fixed rate for a couple of years and then jump to levels of around 13%. Should borrowers find in a few years time that they are unable to re-finance (tighter lending standards on the back of this recent scare ?) we could well see delinquencies rise significantly and I'm not so sure the wider bond markets could remain quite so sanguine.

http://ml-implode.com/

The latest Bank of England Inflation Report shows that the MPC believes that one more rate hike (to 5.5%) should be enough to send CPI back down below the target (2%) by the 2009 horizon date. We know this because the Bank shows where it projects rates to be on the basis of both unchanged rates (5.25% - CPI slightly higher than target), and market expectations of rates (a hike to 5.5% by mid 2007 and then probably on hold, which results in CPI slightly below target). The Bank did state though that there is "greater-than-usual" uncertainty about their forecasts - not only thanks to energy prices, but also wages and inflation expectations. The Bank's measure of inflation expectations has edged up lately - it's worth remembering Paul Tucker's comment about November's rate hike - "I concluded that it was essential for the MPC to act in a way that was most likely to keep inflation expectations anchored".

On a different, but related note, I found this quote in a recent UBS presentation fascinating: Professor Kenneth Rogoff of Harvard said that "as long as the central bank targets inflation in the overall price level, which it can over sufficiently long horizons, cheap goods from China simply imply that other goods must become more expensive. From this perspective, one might say that China is exporting inflation to other sectors of the economy". In other words central banks have kept rates too low - the collapse in goods prices driven by China sent inflation rates down (for example in the UK, deflation in clothing and footwear was at one time running at 6% per year), but this was an exogenous shock, and out of the control of central bankers. In order not to have overall inflation rates fall below the bottom of their targets they had to generate higher inflation in the remainder of the inflation basket, for example in domestic services, by cutting rates. As they cut rates they stimulated already robust domestic demand, made mortgage finance substantially cheaper, and we can see the consequences in housing markets today.

A triple-C rating (CCC) is known as "the hooks" in junk bond parlance. Sounds a bit better than Moodys who define them: "…to be of poor standing and are subject to very high credit risk". Despite that definition they have been doing very well over the last couple of years and yesterday the average spread on European bonds rated CCC & below reached 359 basis points, the lowest on record. To put this in perspective, CCC spreads reached a peak of 3845 basis points on 1st October 2001 (yes, that's a 38.45% excess yield over government bonds). It's the same story in the US, where spreads on bonds rated CCC & below now stand at 452 basis points, also a record low. This is important because US spread history for the poorest rated bonds goes back to 1988, whereas European high yield data is only available from 1998.

Are CCC rated bonds compensating us enough for default risk? Based on historical default rates, the answer is a resounding "no". Moody's most recent annual default study looks at global default data from 1920-2005, and on a five year moving average, the historical global default rate for CCC rated bonds is a rather worrying 29.7%. So, if you bought a CCC rated bond now, based on an historical default rate, there is almost a 1 in 3 chance that the bond you bought would default over a five year period.

It's all very well looking at historical averages, but are we in an "historically average" credit environment right now? Again, definitely not. The global economy had one of its strongest years ever in 2006, which goes a long way to explaining why defaults have remained so low. In Europe, following the default of Schefenacker, only 2 out of 155 companies’ bonds are trading at distressed levels (ie yielding 10% more than government bonds) indicating that they are likely to default soon.

Even though balance sheets are generally very healthy and the credit environment is very supportive, it is difficult to be bullish on something that is the most expensive it has ever been. In my funds I am being cautious on triple-Cs. Where I do hold them it is because they have short maturities or we think that they are likely to be refinanced. I’m not hooked

Defaults are few and far between in the European High Yield market at the moment but we have another today as Schefenacker, a German auto supplier that makes mirrors and lights, has announced a financial restructuring. Holders of the €200m bond issued in February 2004 have been offered 5% of the equity (see press release).

This should serve as a reminder to the current jubilant credit market that companies can go bust, although I suspect that it will be seen as part of the auto industry malaise that the rest of the market is insulated from. It should also question recovery rates. Schefenacker bonds are trading at around 10% which is much lower than the “normal” 40% assumption that is the perceived wisdom. With more loans and second lien loans ranking ahead of the bonds, we should expect recovery rates to be lower over the next credit cycle.

Friday's statement from a group of private equity houses that they were "in the preliminary stages of assessing" a possible offer for Sainsbury saw its shares rally 17% and the CDS market jump from spreads in the mid 27 bps out to 75 bps. CDS (credit default swaps) reflect the cost of 'insuring' against an issuer defaulting on its debt - the higher the risk of credit deterioration, the higher the premium.

During the first half of 2005 Sainsbury's CDS contracts traded in a range of 90 bps to 130 bps reflecting the rather poor performance the company was experiencing in a demanding sector. The second half of the year saw a gradual tightening in spreads reflecting an improving credit profile as management began to show signs of turning things around. By the end of the year Sainsbury CDS was trading at around 57 bps, largely in line with its peers.

However, by the end of February 2006 Sainsbury's CDS had collapsed from the high 50s to the mid 20s and eventually settled in around the high teens a month later. The driver for this move is a technicality in the CDS market. If a credit event takes place, the 'insured' party has an obligation to deliver qualifying bonds or loans, and in exchange receives his/her payout from the protection seller (in the same way that if you crash your car, the insurer pays out, but then owns the wreck). The issue in February 2006 was that Sainsbury announced they intended to re-finance their outstanding debt in a move which included buying back their outstanding bonds. This meant that if a credit event was to occur then a protection buyer would be unlikely to be able to fulfil his/her part of the bargain - thus making the value of insurance dramatically lower. (The reason the CDS didn't trade to zero will become apparent.)

So why is Sainbury's CDS currently trading around 90 bps? If private equity were to get their hands on Sainsbury, far from a certainty, then they would be very likely to lever up the balance sheet (by issuing loans and bonds) thus increasing the probability of a default. In theory this should see the CDS trade above the highs of 2005. The reason why the CDS hasn't yet reached new highs is twofold: firstly we don't know what the ultimate fate for Sainsbury will be, but crucially we don't know whether any debt issued would 'qualify' as deliverable under the existing CDS contracts. In theory the CDS price should be a function of weighted sum of the various potential outcomes for Sainsbury and that is very much open to interpretation and guesswork. I imagine we will yet see some more volatility in Sainsbury CDS.

The former Governor of the Bank of England, Lord Eddie George gave the keynote speech at our Annual Investment Forum last week. You can read the full text below. In short Lord George argued that there has emerged a political and public consensus in favour of financial and fiscal stability. This means that interest rates and inflation should remain much more stable (and lower) than they might have been in the bad old days of non-independent central banks, and imprudent fiscal policy. He did however warn about the re-emergence of protectionism as a threat to the global supply side and as such the possibility of lower global growth than we might otherwise achieve. Finally he warned that returns from private equity and alternative investments might disappoint - although he added that he didn't see any systemic threats to the real economy from those asset classes. Click "read more..." below to read Eddie's speech.

Lord Eddie George's Speech:
"I plan to talk about the state of the global economy and some of the recent developments in financial markets. But I’d like to begin by reminding you of some of the fundamental changes that occurred – very gradually - in our whole approach to macro-economic management over time in the UK, but also, from different starting points and to varying degrees, in much of the rest of the world. I think those changes help to explain why I believe the outlook for the real economy may be more stable than in the past and less volatile than is often suggested by financial markets and media commentators.

Soon after I joined the Bank in the early 1960s I was sent off to Moscow for a year to study the Soviet economic and financial system – as the extreme example of central planning and control. I don’t know what crime I’d committed to deserve such punishment but it was a seminal experience for me. It wasn’t so much what I saw there, though it was clear that the system was not working very well. What really made an impact on me was on my return to the UK, I noticed for the first time just how centrally controlled we too were in this country. I suppose I’d grown up in that atmosphere and simply took it for granted.

The Bank at that time devoted much of its time and energy to administering direct controls of all kinds over the financial system – you will remember foreign exchange controls; credit controls under which we told banks how much they could lend, what fed markets and in what form; rationing of access to capital markets through the equity queue and so on. But it wasn’t just the financial system that was controlled from the centre in this way. Across the wider economy we had prices and incomes policies; extensive public ownership of major sectors of industry – with powerful trade unions secure in the knowledge that the employer couldn’t go bust; and we had marginal rates of income tax that at one point reached 83% on earned income and an unimaginable 98% on investment income!

Happily all that has now largely gone, though it took 20-30 years to bring it about. Gradually we moved to a much more market based economy. Of course we still have masses of rules and regulations in the place of the direct controls – I’ve never seen a business opinion survey that didn’t have excessive red tape near the top of its list of complaints. And we need regulation if markets are to be reasonably fair as well as reasonably free – as they must be if they are to serve their fundamental purpose of allocating resources, whether human or physical or finance resources, to wherever they can be most productively deployed. If we simply had a free-for-all, resource allocation would be hopelessly distorted – though I recognise we can always have too much of a good thing, or even a necessary, thing! But the difference between what we have today and what went before is that today we’re not told what we can and cannot do: today we’re told the criteria we must meet and the standards we must observe in doing whatever it is we choose to do. And that leaves for more room for both producer and consumer choice through market competition

All of that was on the supply side of the economy, which was critically important because it is the supply side that determines the rate of growth of output and the level of employment and income that we can hope to sustain. But there were equally fundamental to our approach to macroeconomic management on the demand side.

Throughout the first half of my Bank career fiscal and monetary policy was used more or less in tandem to manage overall demand, with the aim of managing what was seen as a trade-off between growth and employment on the one hand and inflation and the balance of payments position on the other. The result, you will remember, was a go-stop policy cycle that contributed to the notorious boom-bust economic cycle. And worse still the situation was becoming explosive with inflation moving higher and higher at each successive peak, reaching 27% in a single year at one point; and unemployment higher and higher at each successive trough, rising well into double digits. We really were looking over a precipice.

But we eventually learned from the experience. We learned that fiscal policy was a cumbersome instrument for managing overall demand in the short term, and recognised the importance of containing the government debt proposition in the medium and longer term. That opened the way to a more distinctive role for monetary policy – now essentially through control over short term interest rates – as the key instrument for shorter term demand management.

And we learned too that there really is no trade off between growth and inflation except possibly in the short term, but possibly not even then given the pervasive influence that the short term horizon came to have on economic decision making, with employers and employees, investors and consumers, all looking to make hay while the sun shone. We learned in fact that stability – in the sense of keeping demand growing consistently broadly in line with the underlying supply-side capacity to meet that demand, stability in that sense, is a necessary condition for sustainable growth, and that has become the near universal central banker’s mantra. It was that understanding that eventually led to operational independence over monetary policy for the Bank, through the MPC with the mandate from government to achieve and maintain its low, symmetrical, inflation target – in effect reflecting stability in that broader sense – accompanied by public transparency and accountability.

Now the real point about all of this is that none of it could have happened without the gradual emergence of a broad political – and public – consensus; and that consensus supported the combination of changes, on both the supply and demand side: any one of the changes on its own would have been ineffective. Operational independence for the Bank, for example, on its own would in my view have been a poison chalice.

As things turned out the UK economy as a whole has performed very much better over the past 15 years or so. Since 1992 we’ve enjoyed continuous quarter by quarter growth, at an average annual rate of some 2.75%. Employment rose to an all-time high; and unemployment fell to a new 30-year low, though it ticked up a bit last year. Inflation has been consistently within the government’s target range, and interest rates have on average been just about as low as most of us can remember.

And, critically important, the political and public consensus that made all this possible remains robust. It’s on this basis that I am reasonably optimistic – which is strong language for a central banker, even a retired central banker – that we will continue to see reasonably steady growth and continuing low inflation over the next few years which is as far as anyone can realistically look ahead. Now that I’m no longer in my day job, I can tell you with complete confidence that interest rates will remain where they are – unless they either go up or down! But, more seriously, I’m totally confident that any movement in interest rates will be “measured”, with any further rise reflecting the strength rather than the weakness of the economy. I’m bound to say that I find the excitement displayed by many media and financial market commentators about a quarter of a percent this month or next somewhat exaggerated. I can remember the days when they moved by two percentage points at a time and at one point hit 15%!

But let me move on to the state of the global economy, where, as I say, we’ve seen a similar evolution, from different starting points and to varying degrees, in the approach to macro-economic policy. And here, after the sharp slowdown into mild recession after the turn of the century, a fairly solid recovery, particularly in the US. In fact among industrial countries the world became dependent upon US demand growth, which contributed to fears about global imbalance. Europe and Japan argued that the US should address these fears by cutting back on consumer and government demand; whereas the US pointed out that this would mean persistence of global weakness and that the problem of imbalance would be better addressed by stronger consumer demand elsewhere. There was a fairly long period of stalemate. But happily we are now seeing some moderation of consumer demand growth in the US – not the crash that was widely predicted – in the wake of the measured rise, to a more “normal” level in US interest rates, and we are also seeing moderate concurrent recovery of demand in both Europe and Japan, where interest rates remain stimulatory. So the dark clouds of imbalance on the horizon have lifted a little. But the problem – which was never going to be resolved overnight – has not gone away; and we may, as a result, see periodic bouts of nervousness over the dollar exchange rate; but that doesn’t mean a sudden crash.

The other major threat – of a year or so ago – was the threat of accelerating inflation stemming particularly from the sharp rise in oil prices. In fact we survived that remarkably well. Oil prices have declined significantly since then, having a negative effect on inflation more recently. The price of oil remains substantially higher than it was, and it probably needs to remain high to provide a commercial incentive to alternative energy sources, but it is the rate of change which affects the rate of inflation, rather than the level.

A third concern has been the re-emergence of protection pressures in a number of industrial countries. The stalling of the Doha round of trade talks is one example of this, but we’ve also seen protectionist trade measures and resistance to foreign takeovers of so-called “national champions” in some countries, reflecting resistance to globalisation. I find it particularly paradoxical that the US, which for years has preached the gospel that “a strong dollar is good for the United States” should suddenly – with European support – start to bully China into a dramatic revaluation of the Renminbi. China is a country in transition and may well, in the fitness of time, conclude that a stronger Renminbi is good for the welfare of the Chinese people as consumer demand expands, but for the present a major priority is to create employment for those people migrating from the rural areas, which is in the interest of all, not just of China. A sudden, sharp, appreciation of the Chinese currency would have wholly unpredictable consequences for the whole of the global economy. Happily China has not succumbed to the external pressure.

What such protectionist instincts represent is a desire to hold on to what we’ve had. But I think we’ve learned, in this country certainly, that the approach is ultimately a blind alley. The answer surely is to encourage supply-side flexibility and new business activities, and the creation of new jobs through education and training, in areas where we can hope to establish and maintain a comparative advantage. I have every sympathy with people who lose their jobs – but surely their position is much more bearable if they have a reasonable chance to find new jobs; and the contrast between the labour market data in this country compared to some of our European partners is significant in the context.

I don’t suggest that the protectionist pressures we have seen will cause economic growth to stall – even in China and India, which are contributing so substantially to it. I see the danger more as a lost opportunity to increase global supply side capacity and the rate of growth that we can, collectively, sustain.

So, all in all, I anticipate relatively steady growth in the world economy as a whole over the next few years, with perhaps some mild slowdown in the US, somewhat faster growth in Europe and Japan, and continuing very strong growth in China, India, Russia and some other emerging and transition economies that, together with continuing relatively low inflation, reflecting reasonably disciplined demand management policies, certainly appears to be the expectation of most of the official forecasters.

Of course, nothing is certain in economic life, but this prospect does not suggest major shocks to the financial system emanating from the macroeconomic side. But what about the other way round? Macro-economic and financial stability are like love and marriage – they go together like a horse and carriage! So let me conclude with a few remarks on recent developments in financial markets.

Since the end of the dotcom bubble and the recession in much of the industrialised world that we saw at the beginning of the present decade, and the dramatic reduction in interest rates and expansion of liquidity designed to promote recovery, we’ve seen some fairly radical changes in financial markets internationally – driven by a desperate search for yield. I confess I’ve found it hard to keep up with it all since I left my day job. My rule of thumb – and no more than that - used to be that “normal” interest rates – whatever that meant exactly – would be close to 5%, reflecting 2-2.5% real and 2-2.5% inflation. I’d add a bit – not much – for low grade sovereign debt, and rather more for commercial risk – somewhat less on property than on major equities. But I couldn’t get to a “normal” average return on mainstream equities above about 8%.

Since I retired we’ve seen a considerable increase in the sophistication of debt markets, with more different tiers of risk, and an expansion of derivatives trading, allowing risks to be hedged - or acquired – much more easily. And we’ve seen a continuing increase in the numbers and variety of hedge funds and a massive surge of money going into private equity investment, which is often very highly geared. Now, in principle I see these developments as positive – as you will have gathered from my earlier remarks – I’m basically in favour of free markets. They should – again in principle – improve the pricing of financial risk and the efficiency of financial resource allocation. But I suppose I have two main concerns in the present situation. The first is that given the pace of many of these developments and their technical complexity many end-investors have little experience of them and perhaps an imperfect understanding of the nature of the risks. I gather that it is also time that confirmation and settlement arrangements need to be improved. But I’m sure I don’t need to tell this audience that you have to know what you’re getting into.

My second concern is that the rush into “alternative investments” may result in too much money chasing too few opportunities so that they become over-priced. End-investors are putting a lot of trust in the ability of the alternative investment intermediaries to make the right choices – and there have been some notable calamities, as well no doubt as others that have attracted less public attention: performance data is not universally well-advertised, especially when the performance is not so good! But, of course, if investors are only cautious they may well miss out on substantial returns, which is no doubt why we are seeing the rush into alternative investment. Most end-investors I’m familiar with are in fact fairly cautious about the amount they include within their asset allocation – and of course they are typically paid to asses the risk.

Perhaps because I’m retired I am less concerned than perhaps I should be that the risk to individual investors is likely to translate itself into a risk to the stability of the financial system as a whole. Of course anything is possible! But my sense is that in a context of a reasonably stable real economy – particular private equity values may disappoint some investors and some providers of the leverage that accompanies private equity investment may even lose money, the spread of risk is sufficiently widely dispersed for there not to be a sudden loss of confidence in those investors and lenders that could be imperilled which would result in a rush for the exit by those who have reasonable claims upon them. So I don’t see a systematic crisis looming that would undermine the real economy either. But, of course, I may be completely wrong!"

Financial and media commentators spent much of the second half of 2006 predicting a US housing market crash and an economic slump. True, the housing market did weaken last year, but US GDP figures out yesterday paint a completely different picture.

US GDP in the fourth quarter last year was 3.5% (annualised), the strongest Q4 number since the sizzling 7.3% recorded in Q4 1999. Looking at US GDP on a year-on-year basis shows a similar story - US growth in 2006 was 3.4%, stronger than 2005, level with 2004, and only marginally behind the 3.7% record in 2003. Not since 1999 has the US economy grown significantly faster, when it expanded by 4.7%.

How did bond markets react to the news? Well, not as dramatically as you might think, largely because US investors have already significantly altered their interest rate expectations over the past two months. At the beginning of December, the US bond market was fully pricing in 3 US rate cuts, with about a 50% chance of a fourth. Today, the US bond market is only pricing in an 80-90% chance of a US rate cut this year.

But is a rate cut consistent with a booming US economy and US CPI inflation at 2.5%? I don't think so. I expect US rates to remain on hold over the medium term - in fact, depending on how things pan out, there may even be another rise on the cards.

My favourite chart over the past few years has been mortgage approvals plotted against house prices, with a seven month lag. The number of mortgage approvals are a fantastic indicator of what's going to happen to house prices half a year down the line, which in turn goes hand in hand with economic growth and offers a good clue as to where interest rates are heading.

The link between mortgage approvals and house prices is fairly intuitive. If someone goes to a bank or building society and gets a mortgage, you know that they're going to be buying a house pretty soon. And in the UK, the supply of houses is essentially fixed, so if demand for houses goes up, house prices inevitably go up too.

I've watched mortgage approval data extremely closely over the years. In mid-2004, for example, mortgage approvals began to fall sharply. The bond market was expecting a series of interest rate rises, but I thought this very unlikely. I positioned my funds long duration, and sure enough the housing market stalled and the rate rises never materialised. In fact, UK rates were eventually cut in mid 2005 as the economy weakened considerably, and house prices only just succeeded in staying in the black. Being long duration boosted performance as interest rate expectations adjusted.

By the summer of 2005, UK rates stood at 4.5% and the bond market was expecting rates to fall. But mortgage approvals were growing fast, and I therefore thought that a rate cut was very unlikely, and evidence of a rebound in the economy could mean rate rises. Sure enough, house prices in 2006 were strong and economic growth surged. This, coupled with a steady rise in inflation, meant that the Bank of England hiked rates in July 2006 and then again in November and at the beginning of this year. This time, being short duration was a great help to performance as investment grade bond markets had a tough time in 2006.

Mortgage approvals reached 129000 in November, the highest since late 2003, but on Tuesday it was announced that mortgage approvals fell to 113,000 in December, the lowest recording since April 2006 (but still not that low). The key question is whether this is a hint that recent hikes are taking some steam out of the housing market, or is it just a one-off soft reading and January figures will show a sharp rebound? My portfolios are still very short duration given where UK inflation sits, but the next couple of months could be absolutely crucial. It's inevitable that the rate hikes witnessed in the UK will start to bite at some point this year, and when they do, there will be a great buying opportunity in the bond markets. I don't think we're there quite yet, but we're getting closer.