Shaw Capital Management Korea February Newsletter: Article two of three - Bond markets in mainland Europe have also fallen back towards year-end. There are signs of a modest improvement in the background economic situation in the euro-zone; and this seems to be persuading the European Central Bank to withdraw some of the liquidity measures that it introduced to counter the recession as part of a general tightening of monetary policy that might soon include higher short-term interest rates.

Shaw Capital Management Korea February Newsletter: Article two of three - But a more serious immediate consideration for the markets has been the decision by some of the rating agencies to downgrade the credit rating of Greek government bonds, and to warn that other periphery member countries of the euro-zone have been placed on "credit watch" and might suffer the same fate. Investors have responded by widening the yield spreads between the bonds of member countries, and by pushing the overall level of yields higher. The markets appear to be expecting that the process will continue. The Fed appears to agree with this more optimistic view, arguing that economic activity is continuing to pick up, and that the deterioration in the labour market is abating. for weaknesses elsewhere.

Shaw Capital Management Korea February Newsletter: Article two of three - There is also a fear that the contraction that is occurring in banking lending, and in the money supply, may be leading to another credit crunch this year that could extend the economic slowdown. Bank loans to businesses were 1.9% lower in November 2009 than in same month in 2008, and M3 money supply was 0.2% lower, and has been shrinking now for several months. Since an expansion in banking lending was a major plank in the European Central Bank’s efforts to combat the recession, this latest evidence of a contraction is a major policy failure, and should be persuading the ECB to move very slowly in dismantling its emergency measures; but all the evidence suggests that it is preparing to act. The latest meeting of its governing council left short-term interest rates and overall monetary policy unchanged; but subsequently the bank chairman argued that some of the existing liquidity measures were no longer needed and would be gradually replaced. This was a disappointment for bond investors, not only because such action might be premature and extend the recession, but also because some of the funds that had been made available had been used to support government bond issues.

Shaw Capital Management Korea February Newsletter: Article two of three - However the more serious consideration was the downgrade of Greece’s credit rating, and the threat that other member countries of the euro-zone might receive similar treatment because of the increased risk of defaults. Bond issues in the zone reached the equivalent of $1350 billion in 2009, and are likely to exceed that figure this year, with Greece alone needing to sell $83 billion, and likely to try to rely on overseas investors for at least half the funds.

Article part two of three.

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