Bond markets have taken the driving seat

So the Federal Reserve has failed to move its interest rates up again . . . so far. There are two broad explanations for Fed hesitancy, of which more in a moment. Meanwhile, ponder the dynamics of the markets: the fact that, ahead of yesterday's no-change announcement, they had been discounting a cut of 0.5 to 0.75 per cent, the fall-off of the dollar on the exchanges, and the further rise in long-term bond yields.

Together these suggest that monetary policy is increasingly driven by the financial markets rather than by the central banks, and that an important shift has taken place in the balance of power between the authorities and the markets. US markets in particular feel they should be running the show and accordingly punish the Fed when it fails to do what they expect.

This is not just a US phenomenon, for the punishment the markets inflict is by no means confined to the dollar and US bonds.

First, the hesitancy. Central banks never like being told what to do and will try to time action to surprise the markets. The clear demand for a cut in rates may have stiffened a Fed desire to make it clear that timing of the next move (and timing is really the only issue) was its choice and not that of the markets.

There will be some truth in that. But the other broad explanation may have clinched the decision to hold off. For purely procedural reasons it would be more proper to wait until the next open market committee meeting on 17 May, so that the further tightening carried the explicit imprimatur of the Fed's policy-making body. That way, it could be argued, the Fed would be more likely to convince the markets that this round of tightening at least was over.

And that is the key problem. How does one explain the weakness in the US bond market? There is the argument, made in these pages yesterday by Gavyn Davies, that the markets have allowed themselves to become spooked by fears of inflation. He argued, I believe quite rightly, that such fears were unwarranted. It would follow that real bond yields, even at their present levels, are too high.

But it is wholly logical to believe that bond yields are too high and yet hold off buying if the act of buying results in an immediate capital loss as the market continues to slide. Maybe bond yields are too high but while the market is convinced that they will go higher, there is no case for buying now. Strategy may point in one direction, but tactics point in the other.

To attract buyers back and so steady bond prices, the Fed has to convince the markets that this bout of tightening is over: that it might, towards the end of this year or early next, need to have another round, but meanwhile the steep yield curve would create plenty of opportunities to make a running profit. However, while there is the immediate threat of a series of little interest rate hikes through the summer, the buyers will stay away. The acid test of what is the right policy for the Fed is the response of the bond market: if the Fed does not tighten monetary policy by upping short-term interest rates, the market will tighten policy by upping long-term ones.

How have the bond markets accumulated such power? There is an immediate explanation, and a longer-standing one. The immediate reason lies in the tactics of the Fed during the easing phase.

Because it drove down short-term interest rates so aggressively, it created large profits for financial institutions investing in bonds. Borrowing at 3 per cent and putting the money into bonds at, say, 7 per cent is solidly profitable, even without allowing for capital gains on the bonds: a spread of 4 percentage points is far wider than a bank could expect to make on its normal commercial lending.

These profits enabled the banks, battered by unwise lending policies, to rebuild their capital. But there was a price, for many new bond- buyers were attracted into the market. When it became clear that the interest rate cycle was turning, these institutions, which had built up unusually large (for them) positions, wanted to unwind. This unwinding makes the collapse of bond prices much more brutal than it otherwise would have been.

Behind this fallout is an underlying change in the balance of supply and demand in the bond markets worldwide. Thanks to a string of public sector deficits, there has been an inexorable rise in the ratio of public debt to gross domestic product. For example, the ratio in 1978 in the US was 39.2 per cent; this year it is estimated at 64.1 per cent. And not just the US: every large industrial country, bar one, has seen a sharp rise in this ratio. For the OECD countries as a whole, the rise has been from 41.0 to 68.5 per cent.

The exception? Yes, the UK: we have moved down from 58.7 per cent in 1978 to 52.3 per cent, but that downward move does conceal a U-shaped curve, with the bottom at 34.7 per cent in 1990.

A world where high-quality bonds are relatively scarce is quite different from one in which they are in ample, even excessive supply. That shift, more than anything else, is responsible for the new authority of the bond markets. Given the prospects for a further rise in the debt/GDP ratios, expect the bond markets to continue to growl.