Personal Finance: A panicky flight to safety
Saturday 10 October 1998
The one thing on which everyone in the market seems to agree is that what we need now is concerted interest rate cuts to head off the threat of worldwide deflation. That is what we are getting, but far from celebrating the news, the markets are already clamouring for more medicine even before they have had time to digest the first instalment.
Even those of us who have had many years to learn that nothing in the City is ever done by halves can still be confounded by the speed and intensity with which normally sensible financial institutions start twitching uncontrollably at the first sign that their world may be facing potential difficulties.
My view is that, while the City is usually right about the next direction the markets will take, its reactions are often ludicrously exaggerated.
As Alan Greenspan, the Chairman of the Federal Reserve, observed this week, there is something highly unusual about the excitable and often conflicting messages which are being signalled by current valuations in the markets. "I've never seen anything like it" is how Greenspan summed up his response to questions about the recent dramatic flight by investors into government bonds. In just two months, funk money has sent the price of US and UK government bonds soaring.
The US long bond yield - the rate at which you can lend money to the US Government for 30 years - has now settled firmly below 5 per cent. This is not much more than the yield at which you can buy an index-linked US Government security (which looks an infinitely better bet). The equivalent UK gilt is now yielding a remarkable 4.4 per cent, which is the lowest rate I can remember for a government bond of that ilk.
Although I have long urged the case for buying gilts, the current surge in gilt prices now has all the signs of another classic asset price bubble in the making. It represents a flight to quality on credit grounds, as governments like ours don't usually default.
But buying a long term government bond on a yield of little more than 4 per cent, when inflation is still at 3 per cent (albeit falling) cannot by any stretch of the imagination be described as a flight to safety.
Another measure of the extreme changes which the current crisis are making to valuation levels is evident when you look at the relationship between bond and equity yields, which have also entered new territory. With the stock market now yielding 3.5 per cent, the gap between equity and gilt yields, a traditional benchmark of relative value, has narrowed dramatically.
Indeed, as the FT pointed out this week, the yield on one sector of the market, smaller company shares, is actually now above the yield on gilts - for the first time in at least 30 years.
The figures in my chart show how the respective yields on gilts and equities have moved over the past 15 years. The trend for both is firmly downwards, as you would expect in a world of real and enduring falls in inflation. The ratio between the two yields has now fallen from its typical range of around 2 times to less than 1.4 times.
What the figures are saying is that either shares are seriously undervalued at current levels, or that gilts are substantially overvalued. They cannot both be right. It is a money making opportunity if you can decide which one it is.
The way that the dollar has suddenly reversed direction this week also seems to be another important thing to watch. If you care to think of Mr Greenspan as the pilot of the world economy, what he is trying to tell us is that the readings on the instrument panel in his cockpit have suddenly all gone haywire. How real the danger is remains to be seen. Whatever the outcome, it's still hard to believe that lending money to the government at 4.25 per cent for 30 years is anything but one more case of hope triumphing over experience.
Having boasted a couple of weeks ago about the value of on-line information for investors, I must now confess to giving you the wrong web site address of Interactive Investor. It is: http://www.iii.co.uk - my apologies
Independent Partners; request a free guide on NISAs from Hargreaves Lansdown
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