It now seems clear that the June meeting of the Federal Reserve Open Monetary Committee signalled the high- water mark for the US bond market. With the Fed apparently reneging on its assumed role as the bigger fool, or buyer of last resort, the upward momentum in fixed-income markets faded, failed and then reversed.
With the end of this tremendous bull run has come a reassessment of the economic conditions prevailing in the US. In the way that only they can, bond econo- mists seem to have spun from bust to boom in a matter of weeks. A cynic would observe that the economic forecasts tend to follow, rather than lead, the bond market.
Here we have echoes of early 1999. Then, in the wake of the LTCM hedge fund bust, we saw forced buying of US treasuries driving yields on the 10-year bond from 5.5 to 4.1 per cent. Economists followed suit, with year-end forecasts of "Armageddon", "Asian Contagion" and the usual nonsense about over-indebted US consumers. But economic activity refused to co-operate and within six months yields were back above 6 per cent and talk was of co-ordinated global GDP growth and buying cyclical stocks.
In fact, the data in 1998-99 never actually supported the bond rally, just as it never supported the recent run. In effect, deflation was invented to justify the bond bull market of 2003 in the same way the new economy justified the equity bubble in 1999-2000. The equity market is currently pricing out the depression scenario painted to support the bond run. It is not yet pricing in a boom.
It should be remembered that money markets are only interested in economics in so far as they believe it will affect the policy of (usually) the Fed. Thus, even if you did not believe in deflation, it was entirely rational to buy bonds on the basis that you thought the Fed did - or, more importantly, that it would act to prevent it. So the mere mention of the word deflation produced a drop in 10-year bond yields from 4 to 3.2 per cent in little over a month. It has taken a similar time to reverse, not because the threat of deflation has changed but because the perception of policy has.
In the meantime, household and corporate America took advantage of a very attractive window of opportunity to re-finance their balance sheets at bargain levels. This ability, in effect, of US households to refinance their mortgages at a new 10 or 15-year rate ,with little or no penalty, should not be underestimated as a driver of US growth. But crucially it is at the long end of the bond market that this takes place, a fact that will not have escaped the Fed's notice.
By contrast, UK households are hugely exposed to short-term rates through our crazy mortgage system. Fine when rates are falling, but in the next phase this represents a serious constraint on the economy. Higher short rates will immediately "tax" the UK consumer, but leave the US consumer unaffected. No wonder Gordon Brown is keen to move the UK to some form of fixed-rate system.
So with the momentum that drove bonds up now pushing them down, what of equities? We believe they entered a new, cyclical bull phase in the second quarter of this year The setback in bond markets will focus investors on the broadly positive economic conditions that have been ignored as bonds buckled. But talk of a lack of a boom is disingenuous; to deny a bust is not to forecast a boom. Indeed, should we see anything like the conditions required by the "double dippers" to finally acknowledge growth is taking place, we would probably be at the end of a cyclical recovery in profits/rally in equities rather than at the start of it.
Mark Tinker is a partner at the stockbroker Execution. firstname.lastname@example.org