Hamish McRae: The markets are just warning that there may be trouble ahead

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The Independent Online

We are at one of those moments in financial markets when the reality may not have changed much but perceptions have clearly shifted.

The shift is about risk: the assessment of risk, the willingness to accept it and the premium to charge for it.

The most visible effect for those here in Britain has been the fall of the dollar, with the pound now trading well above the two-dollar mark, just in time for summer hols in the States. Actually, the fall has been even more evident against the euro, now at an all-time high against the dollar.

But the decline of the US currency is a symptom of something deeper: the loss of confidence in the US debt markets over higher-risk bonds. There is nothing wrong with high-risk anything, as long as those risks are understood and allowed for in the yield. Higher risk equals higher reward: no problem. But when the premium has been squeezed down and/or the purchasers don't understand where the risks lie, there is the danger of sudden disruptive movements in the markets. Something disruptive is happening now, though the gravity of the shift and the consequences are far from clear.

It may turn out that the consequences are quite benign: that this is a healthy correction of an over-optimistic market environment, but the fundamentals of the world economy remain as positive as ever. Let me give you that argument first.

There is no doubt that the prospects for world economic growth have picked up in recent weeks. The European economy will have its fastest growth for about seven years; here growth will be around 3 per cent; even the US, where there has been a sharp slow-down, will see about 2.5 per cent growth; and the Asian giants race on as before. A new paper from Credit Suisse argues that the dangers, if any, come from too rapid growth, not too slow.

It is an interesting argument. The most obvious consequence of faster-than-expected growth is higher-than-expected inflation and higher-than-expected interest rates. Credit Suisse notes that whereas a few months ago the talk was of cuts in US interest rates now there is a possibility that the next move might be up. The European Central Bank has signalled further rises in the autumn and we in the UK face the probability of 6 per cent base rates later this year.

You can see the relationship between the economic cycle and that of interest rates in the first graph. This shows the G7 industrial production picking up again, the leading indicator (plotted three months in advance) suggesting that this will continue, and the change in G7 short-term interest rates (plotted a year in advance) also consistent with this economic recovery running on through 2008. The only obvious shadow might be that interest rates appear to have been too low two or three years ago and might have quite a lot further to rise.

Meanwhile, the rise in rates that has taken place has been enough to frighten the bond markets, and the bank's view is that investors should remain overweight in global equities (to take advantage of faster growth) and underweight in bonds (to ward against interest rate surprises). As for the present ructions in the US bond market, it believes there may be more of these but effects will be short-lived.

My own instinct is that the economic picture is right: that economic growth will run on strongly into the first half of next year and that equities are a better bet than bonds. Any unpleasant surprises will be in higher interest rates rather than slower growth. But it is important also to be aware that this retreat from risk in the bond markets may have more serious consequences than the markets at present appreciate.

Concerns about the fall-out in the US sub-prime (a nice way of saying junk) bonds are set out in another new paper, this time from Citigroup. Its view is generally positive. It feels that the present period of uncertainty will pass and that the second half of the year will see good returns provided the risk is properly priced. The core of this argument is that while the economy remains sound there is no reason to expect a surge in defaults. Moreover, the spread between prime debt and junk debt has been a good indicator of defaults in the past; the markets have been good at anticipating a surge in defaults and they are not doing so now.

You can see that point in the other graph, which goes back over 20 years. In both the last two credit crunches the spread started to rise before the defaults. It follows that while you would expect some further rise in spreads now, the markets are not ringing alarm bells. What has changed in a shift in perception rather than in reality.

The bank does attach one modest health warning to this evidently benign outlook. The US economy has slowed sharply this year and usually a slowing economy leads to a rise in spreads. This time it has not, or at least not to any extent. Why? Well, we don't know - maybe there is so much liquidity about and investors have to put their money somewhere. But maybe there is something wrong here that has not shown through.

My own main concern is that financial instruments have become too complicated. With shares you know where the risk is: if the company folds you lose your money and if it does well (or is taken over) you make an extra profit. If bonds were simply bonds that would be fine. We know those risks and can have a debate about the correct pricing of the risks. But now bonds (and many other debt instruments) are sliced into a whole range of different priorities. If something goes wrong there are people at the top of the queue who in theory have first claim on the assets, then people further down who have a lower claim. It is far more complicated than that because artificial instruments are being created out of the raw material of the bonds. But until these synthetic instruments are tested we don't know where the risk lies.

What I think is happening now is just a warning of possible trouble ahead rather than the trouble itself. To that extent I agree with the judgement of the two bank papers discussed here. What worries me is that when there is a real scare in the markets in, say, a year or two, the world's central bankers will find it hard to cope. We have a Federal Reserve, whose chairman Ben Bernanke has no practical experience of the core central banking role of providing stability for the markets. The big guns of the world's central banks have been directed against inflation. But inflation has been artificially held down by the growing role of an ultra-low-cost producer, China, on the world stage.

It is the reverse of the oil shocks of the 1970s and 1980s, when there was a sudden external shock increasing inflation. As a result - and this is a global issue, not just a US one - the world had too loose monetary conditions. The financial markets have become accustomed to that. Now, we are moving to tighter conditions and this little twitch, exemplified by the fall in the dollar, is a market warning of bigger ructions to come. But those ructions are still some way off.