Bond market key to US confidence

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The Independent Online
Virtually every set of economic data published in the US suggests the Federal Reserve will have to lean harder against the recovery in the months ahead. The key issue for financial markets is whether it will do so sufficiently vigorously to allow a reasonable return of confidence in bonds.

Yesterday gave a good example of the sort of figures that have been emerging from the US in recent months. The problem, as always, is that there is too much raw information being produced about the economy, which means that it is always very difficult to pick out clear signals from the background noise. Each new figure is earnestly discussed (and compared with 'market estimates') as though it were of tremendous importance, when actually many figures are subsequently revised and the only thing that really matters is the general pattern that the figures suggest.

So yesterday we had some hint of rising inflation in the producer price figures, a neutral signal from the retail sales data (down but as a result of special factors), and confirmation of steadily growing employment. But the really interesting news came in the revisions. Sharp upward revisions for the retail sales of the two previous months show that second-quarter consumption growth was very strong indeed.

These figures have policy implications. There is enough momentum here to withstand a rise in short-term interest rates - and sufficient concern over inflation to warrant one. Expect a rise in the US discount rate soon, probably as early as next week, with the main issue being whether this should be 0.25 per cent or 0.5 per cent.

Assuming that the Fed does tighten soon - if not next week, shortly afterwards - what then?

It is fairly easy to project how the US economy might develop over the next two to three years. Naturally any such projection is liable to be badly wrong, but it is at least perfectly plausible that the economy will move to slower growth without a serious surge in inflation. All it needs is higher interest rates.

So a sketch of the US economy over the next couple of years might look like this. Consumption, currently growing at between 3.5 and 4 per cent a year, will come down to a sustainable 2.5 per cent. This will restrict the growth of imports.

Exports will be strong, thanks in part to the European recovery, in part to a rise in imports by Japan, and in part to a better economic performance in Latin America. As a result, the current account, which this year will be in deficit to the tune of about dollars 130bn, will come back below dollars 100bn in 1995, and may be well below in 1996.

It needs to if the dollar is to be sufficiently secure not to lead to imported inflation. And inflation? There will be some rise in the rate of increase of consumer prices, perhaps to a little over 3 per cent, but there need be no take-off. And if the longer-term forces that are holding down prices throughout the industrial world continue to exert themselves, even that 3 per cent could be too high.

Against this sort of economic background it would be reasonable to expect financial markets to become both calmer and more confident. The key is the bond market. Once that 3 per cent figure is accepted and can be seen as the peak of the cycle, it would be perfectly reasonable to expect long bond yields to come back below 7 per cent.

A 4 per cent real yield is quite adequate by long-term historical standards, and were inflation to fall to 1 to 2 per cent during the late 1980s, the real yield would be correspondingly increased.

Once confidence can return to the bond market, US equities, while still expensive, would not appear exceptionally so. Two years of solid profit growth would bring p/e ratios into the middle of their post-war range.

In short, it is possible to sketch a comfortable scenario for the US economy over the next two years and to see positive, if unexciting, prospects for financial securities. But it does require much greater confidence in the determination of the Fed to tighten policy in the face of a rise in inflation than the markets have at the moment. The most important single measure of such confidence is the bond market and in particular its reaction to the next interest rate move by the Fed: will long bonds rise or fall?

There will be implications here too, for if all international markets are linked the UK markets track the US most closely.

It is beyond dispute that we are going to see higher short-term interest rates in Britain this autumn. But the reaction of gilts is uncertain. By rights they should recover sharply as the authorities' commitment to low inflation is demonstrated. But if US bonds fail to benefit from higher dollar rates, it would be over-optimistic to expect gilts to enjoy higher sterling ones.

If that is so, though, and you believe that the long-term trend of inflation is still down, they become an even better buy.