Confidence signal

ASPEN, Colorado - The relentless driving down of long-term interest rates has become the dominant feature of US finance in recent weeks. Most obviously it has been the power behind the surge in Wall Street - indeed it is the only real justification for present valuations, which are very high by historical standards. But the fall will, if sustained, become much more than an investment phenomenon. It will start to have big economic and social effects that Americans are only just starting to debate.

The investment impact of the decline in rates is remarkable. This week the yields on the benchmark 30-year US treasury bonds are around 6.3 per cent, with the last half percentage point coming since 23 July. At the end of last year the corresponding yield was 7.4 per cent. The effect on an average long- term bond portfolio would be a total return (interest plus capital growth) so far this year of 16 per cent, more than three times the average annual gain for the last 60 years. This is vastly better than the return on US equities, notwithstanding Wall Street's surge. The Standard & Poor's 500 share index has risen by just over 5 per cent, even with all dividends re-invested. This has been a bull market in equities, but an even bigger one in bonds.

Yet the bond markets do not feel overheated in the sense that there is a great buying frenzy. Less than half the fund managers polled this week by Market Vane are bullish on bond prices. Arguably this in itself is positive, for if all the professionals were convinced prices were going to soar, it would be the time to be cautious]

The obvious threat would be some upward movement in inflation, but there is no sign of that. Quite the reverse. Consumer prices are rising at an annual rate of 2.8 per cent while, more important, wholesale prices in the last three months rose at an annual rate of only 0.8 per cent (they actually fell 0.2 per cent in July). Equally encouraging, fewer companies now expect to increase their prices in the second half of this year than six months ago: 28 per cent against 42 per cent.

At some stage the interest rate cycle will turn, though given the slow, sober US recovery this could be a year or even 18 months off. Talk of a rise in short-term interest rates this autumn seems to have faded. But even when the bond market does turn, it is perfectly possible that the rise in long-term rates will be modest. It would be plausible to have long rates rising from a trough of, say, 5.75 per cent to, say, 7.5 per cent. That would be unpleasant for people who bought bonds at the wrong time, but provided inflation remains low the US would remain fundamentally a cheap money country. It may even be that the low inflation/cheap money psychology is one thing helping to hold back the recovery. If so, low inflation becomes self-reinforcing.

For example this week has seen a sharp fall in housing starts. Part of the reason for this may be the floods, but the weak housing market in general has more to do with a reassessment of property as an investment. People are tending not to over-house themselves in the expectation of making a profit on their home. Instead some at least are trying to save and acquire financial assets instead. Even very low interest rates have failed to stimulate a strong housing recovery.

Low interest rates themselves may be starting to stimulate saving. This might seem counter-intuitive, for a high return on savings ought to encourage people to save more. But if people have a target income they want to receive from savings, then a fall in the rate of return may make them save more: they need a larger capital sum to provide the same flow in income. There is little evidence of this in the figures, but it is a subject that people are talking about, so maybe the figures have yet to catch up with reality.

If this is right, and savings will soon start rising in the US, then a lot of other financial problems become more manageable. For example, the budget deficit becomes much easier to finance. The US problem has never been the deficit as such: it has been the combination of a large deficit and inadequate savings to fund it. Long-term investment projects become easier as well as cheaper to finance, and the US does need money spent both on infrastructure and in industry. A virtuous circle is established.

Too optimistic? Perhaps. It would be much more comforting were savings seen to be rising faster, as they have in the UK. The test will be what happens to inflation and hence to long-term interest rates during the next cycle. If the peak for both is clearly below the peak of the last cycle, then the prospects for the present moderate growth being sustained for a long time would be good. If on the other hand inflation pushes up and long-term interest rates do rise sharply, then the whole recovery could be aborted, and fears about its fragility justified.

The central point is that, in as far as markets signal anything coherent, the US bond market is saying that it is worth lending money for 30 years at the cheapest rate for a generation. Put like that, the market is as confident about US economic prospects as it was in the heady days of the 1950s and 1960s. Talk to business people in North America and they do not radiate that confidence at all. But the plain fact remains that there are more millionaires now in the US than there were before the recession in 1989: 3.7 million households now against 2.8 million then, according to PSI, a Florida research firm. Surely they did not all make the extra money by investing in the bond market?