A growl as bond markets show their teeth
Tuesday 12 March 1996
It is always difficult in the midst of a period of market turmoil to judge how the twists and turns of a few days' trading will be seen in the long march of history. We can, for example, now put the crash of October 1987 into a historical perspective: a serious reaction of a market which had run far ahead of itself, but also a fine buying opportunity in what was still a strongly rising bull trend. At the time we just could see the reaction, not the opportunity.
Now the talk is of 1987 again, with (as noted here last week) the feeling that even if share prices around the world do end the year higher than they began, the end of the bull market will occur in the next 18 months. But when we can see this particular period in perspective I suspect there will be more attention paid to the bond market than to equities, for bonds will be seen as giving the lead to equities. The peak in the bond market will occur before that of equities and therefore be a lead indicator of share prices.
We may well already have passed that peak: bond markets around the world have been in retreat for a bit over a month. The US 10-year treasury yield had come down to 5.6 per cent in the first weeks of the year; by the middle of last week it was about 6.1 per cent, and yesterday it was between 6.4 and 6.5 per cent. If you look at the change in capital values, rather than in yield, that is a fall of about 15 per cent in little more than a month. Had that happened in equities, it would be ranked as a crash.
But it is a long way from noting the sharp reversal in the bond market to arguing that a similar reversal in equities will take place. To some extent the two markets are driven by similar forces, but they can for quite a while move independently of each other, for the links are elastic. Still, if the bond markets continue to head south, at some stage this will unseat equities. So the starting point for trying to "call" the equity markets is to understand what is happening to bonds.
It is probably easiest to think in world terms, rather than in national, because in the medium term all the markets move pretty much together. Perhaps on a 20-year view the interest differentials between countries with hard currencies and those with soft will shift: some currencies will establish a better rating, others a worse. But the lags are long. On paper, French yields ought to be at least as low as German. The country has similar or lower inflation, slightly lower public debt levels, and is in current account surplus, not deficit. If you believe the politicians both franc and mark bonds will in any case be transformed into the new euro at present parities.
The perception of the markets is different: French securities are deemed "worse" than German and so carry a higher interest rate. It is 14 years since the strong franc policy was established, and it still has failed to convince the markets of its durability.
If you think in world terms, then, the question is this: what has happened globally that has led to a deterioration in investor confidence in bonds?
Put aside fashion - markets are always susceptible to that and there will have been some element which simply reflects a change of mood. But behind that there seem to be two main forces at work. One is the lagged effect of a much easier money policy in the large developed countries; the other, growing confidence that the present pause in world growth will be just that and not a harbinger of a serious recession.
What has been happening to money and credit in the Group of Seven economies is shown in the graph. There was no clear trend right through the 1980s, though since inflation was much higher at the beginning of the decade than at the end, the flat lines concealed a loosening of monetary policy, which goes a long way towards explaining the late 1980s boom. Then from 1989 onwards monetary growth and bank credit plunged, the fall associated with the early 1990s recession.
Now look what has been happening in the last year. Both lines are turning upwards. There has been no significant rise in inflation so this represents a marked easing in monetary conditions.
This easing has not yet had any impact on world output for the lags in the system are at least 18 months, perhaps two years. But this easing has helped support world securities markets. Indeed one of the main reasons - maybe the main reason - for the strength of the bull market last year has been high global liquidity. There is a lot of money sloshing about and it has to go somewhere.
But eventually money is likely to feed into goods inflation, as opposed to asset inflation, and that is one fear of the markets. We have seen a sharp rise in the gold price, something which would be absurd were the long-term downward trend in inflation secure. The gold market is not a lead indicator of anything, but it does give a crude measure of the level of fear about inflation.
Whether people are right to be worried is another matter, for this fall in bond prices, if sustained, will have the effect of tightening monetary policy. If you believe in the power of the bond markets as a means of curbing inflation, investors have little to fear in the very long term.
Meanwhile, the markets exert that power by pushing up bond yields. So maybe what bond investors are really fearing is not the resurgence of inflation, but rather the steps that the markets will take to prevent any such resurgence.
As noted above, the second reason for market caution stems from a belief that further growth is secure and that we are therefore close to the bottom of the interest rate cycle. That is probably right, but only probably. Look around the world and you can construct a decent argument to support the "expect a recovery in G7 growth" view. The US looks better than a few weeks ago; there does seem to be some growth in Japan at last; Germany and France will have very slow growth in the first half of this year, but that will bring the prospect of faster growth by the autumn; Italy is OK; so is the UK, thanks to domestic consumers; likewise Canada. Outside the G7, the newly industrialised countries are continuing decent growth.
Now this quite rosy view may be wrong and the world plunge back into recession. In that case there would no rise in short-term interest rates later this year and bond markets (though not equities) might well recover. But at the moment the danger of recession is not particularly evident.
How does all this square with the view that the long-term downward trend in inflation is secure? The answer is simply that in order to bolt down inflation, every now and again, bond markets have to show they have teeth by jamming up interest rates. See their behaviour in recent weeks as a growl.
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