Bonds are lacking in saving graces

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It is always slightly embarrassing to see that when Wall Street is closed, the European markets find it very hard to know how far to jump.

Normally this follow- my-leader tendency is concealed, for there is no great matter to be settled. But yesterday, with New York shut for Washington's birthday, Europe's lack of independence came into the open. The world's equity markets have collectively to decide how badly to react to the sell-off on bond markets that took place at the end of last week. Without some lead from Wall Street they could not do so; London, the largest European market, shuffled down a little and waited.

For those who do not follow each twist and turn of world financial markets, the story runs as follows. Ten days ago, the US Federal Reserve gave the slightest tightening to monetary policy - the idea being that the recovery was secure and bondholders would want to see that it was prepared to lean against any inflationary pressures. But instead of being relaxed, even cheered, by the move, US bond markets threw a wobbly. The return on the longest-dated US bonds, which had fallen to below 5.9 per cent, shot up to 6.6 per cent. If you think in terms of capital values rather than interest rates, anyone who had bought at the top would have lost roughly 15 per cent of their money. This very sudden sharp movement is not supposed to happen in bond markets. Central bankers, at least, were perplexed by the ferocity of the response.

They were also puzzled by the way in which it spread to other markets, including the UK and Germany, which are at a different point of the interest-rate cycle and where there are still some rate cuts to come.

So far, however, the downward adjustment of equity markets has been relatively modest. It may take some weeks for them to make up their minds, but while they do there is always the danger, however small, that they will seek to make the 15 per cent adjustment, too.

US SETS LEAD

That is the story so far. What happens next depends on at least three factors. One is whether most of the adjustment in US bond prices has already taken place, or whether there is a further fall to come. US interest rates are going to rise further. In a year's time short rates could well have risen to 5 per cent. But that could still be consistent with long bond yields only a little over 7 per cent, giving real yields of about 5 per cent. In other words, three-quarters of the adjustment could already have taken place.

If the US bond market does steady, it is quite possible, even probable, that the equity market could hold steady, too. And if US markets steady then European markets could even resume their advance. European bond prices, particularly in Germany, have run a little ahead of economic realities but bonds in the UK still offer a good positive yield. Meanwhile, prospects for equities will be supported by rising profitability as the economies pick up further.

That then is the sensible, middle-of-the-road view: markets realise there are risks and there will be a short-term adjustment. But after a pause, the long bull market could run a while yet.

THE BEAR VIEW

The alternative view comes in two sorts. There is the pragmatic bear view which essentially holds that most of the bull market has passed. So while there may be several more months of rising prices, the risk/reward ratio points to holding cash, not shares or bonds.

But there is also an intellectual version of the bear view which is less easy to express and, perhaps because of this, has yet to receive much attention. What follows is an attempt to explain it.

We have had a long bull market which was great for existing holders of financial assets but which has driven down the real rate of return for would-be holders. Yet the mature industrial world is short of savings. Its ageing population desperately needs to save at this stage of the demographic cycle if the old are not to place an intolerable burden on the smaller working population a generation from now. Yet only Japan saves enough to do so.

True, the rest of East Asia also saves furiously. But enormous investments are needed in infrastructure and pollution control in the region, which will leave little to spare for investment in Europe and North America. The plain truth is that Europe and North America have to save more.

What will persuade us to save more, and in what forms will we choose to hold those savings? Is it really worth buying long-term government bonds if the real return is only 3 or 4 per cent? Investors during the last century wanted real returns of about 5 per cent, which they received typically by getting a nominal yield of 4 per cent and through prices falling by 1 per cent a year. This is a practical question for individuals as well as a question of national policy: to what extent should they lock up their savings - to what extent should we lock up our savings - for what in historical terms are not wildly attractive yields? To pose these questions is not to answer them. But they do at least raise an issue of enormous global importance: how will developed industrial countries get people to save more? Offering paltry returns on govermment securities is liable to cause a buyers' strike. Maybe the sell-off in bonds is saying that buyers are indeed fed up and will require a higher real return in the months and years to come.

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