Don't count on a happy ending for markets

Jeremy Warner On why falling long-term interest rates could be bad news for equities

The portents are strange this year: tornados in Selsey; spring buds in January; floods in the West Country; and now National Savings, which has taken to offering a higher return on short-term deposits than on long- term ones. Long-term savers normally expect to be rewarded for their thrift. What's happening? Has the world gone mad?

Perhaps not quite yet, but the National Savings move does in its own small way neatly illustrate the seismic shift taking place throughout the developed world in investment perceptions and patterns right now.

National Savings this week cut its rates on new pensioner bonds and children's bonds by half a percentage point to 6.5 per cent and 6.25 per cent respectively. Both bonds involve a five-year lock-in. National Savings income bonds, on the other hand, which can be withdrawn on three months' notice, now pay 7 per cent.

The situation is not quite as bizarre as it might seem, since the longer- term bonds are tax-free and therefore continue to deliver a higher effective return than the shorter ones.

Even so, this is a pretty odd turn of events and no mistake. Will we soon be in a position where it is better to save short-term than long- term? Few other savings institutions yet exactly mirror the position at National Savings, but they are all beginning to drift in that direction. Actually, what National Savings is doing is driven, not by madness, but by what's happening in the capital markets. Yields on long-dated gilts are now lower than at any time since the 1960s, but short-term interest rates continue at a relatively high level.

The reasons for this are well rehearsed. The newly independent Bank of England has thought it necessary to drive up base rates so as to choke off perceived inflationary dangers. Meanwhile, long-term interest rates have been falling. This is being caused by three factors. In part it is down to faith in the Bank's ability to hold the lid on inflation. Another factor is convergence with long-term interest rates in Germany as Britain warms to the single currency.

But perhaps most important of all, Britain is mirroring what is happening throughout the developed world. In the US, the yield on the benchmark Treasury long bond is now lower than it has been at any stage since the great depression of the 1930s.

So radically do things seem to have changed that it is now possible to think in terms of falling prices during the next leg of the business cycle. Increased competition thanks to globalisation, the effect of new technology, the Asian crisis and a perhaps overly cautious monetary policy, mean that for the first time since the 1930s there is a real, if perhaps exaggerated, possibility of deflation.

This is having some abnormal consequences for investment returns. One of the big stories this week, for instance, has been the steady stream of announcements from life assurance companies of cuts in guaranteed annual bonuses. Given that both equity and bond prices had a record year last year, many policyholders are going to find this hard to understand.

Again the phenomenon is explained by lower anticipated rates of return, particularly on bonds. Returns on new investment have, in fact, been declining steadily throughout most of the 1990s, but many life companies chose to turn a blind eye to this and continued to declare quite high annual bonus rates by bolstering them from free reserves.

After the sharp gains in gilts last year, the dam can now no longer be held. For pensions business, the fall in returns on gilts has been exacerbated by the abolition of the tax credit on dividends. Annual bonuses cannot continue to be "guaranteed" at former inflated levels. Most life companies are keen to stress that lower annual bonus levels do not necessarily mean policyholders will be any less well off. Lower returns reflect lower anticipated rates of inflation, so, in real terms, policyholders ought to be unaffected.

Indeed, if inflation does sink to zero or less, as it has done already in Japan, it is possible to imagine a situation where real rates of return become higher for savers than they are now or traditionally have been - on bonds at least. As Alan Greenspan, chairman of the US Federal Reserve, pointed out in a speech last weekend, since nominal interest rates cannot fall below zero, falling prices for goods and services raise the possibility of increased real interest rates.

Since the middle of last year, there has been extreme volatility in equity markets, triggered by the crisis in the Far East and fears that this might cause a global deflation. At its worst, this might be similar in its consequences to the great depression of the 1930s. Overly alarmist stuff, perhaps. All the same, falling prices, particularly at a time of rising wage costs, would have serious implications for corporate profits.

At the very least, Western industries, are going to be hit by a flood of cheap imports from the former Tiger economies. No wonder Wall Street is no higher now than it was last August. Wall Street's bull market is already at an end, even if US equities are so far resisting a fully fledged bear market.

The bull market in bonds has none the less continued apace. Normally the two move in tandem, believing that what's good for bonds is also good for equities. Now the two are showing unnerving signs of decoupling. The effect of this has been to narrow the traditional yield gap between equities and bonds from its "normal" level of something above 2 per cent, to something below 2 per cent. Few market analysts expect it to reverse back the other way, so that "safe" bonds once more begin to yield less than "risky" equities, as they did in the 1930s, 40s and 50s. But quite a lot think the gap will continue narrowing.

There are two ways in which this could happen. Either equities could fall, or the bull market in bonds might persist while equities continue to tread water. Of the two, the former possibility looks for the time being to be the most likely. Don't count on it though. If there is no adequate policy response to the problems of the Far East and deflation becomes a reality, even on a limited scale, we might be looking at a combination of bear and bull markets in equities and bonds. Not good, not good at all.

Neil Warnock
football'New' manager for Crystal Palace
peopleGerman paper published pictures of 18-month-old daughter
Arts and Entertainment
'A voice untroubled by time': Kate Bush
musicKate Bush set to re-enter album charts after first conerts in 35 years
Angel Di Maria poses with Louis van Gaal after signing for Manchester United
Arts and Entertainment
BBC series 'Sherlock' scooped a hat-trick of awards on the night. Benedict Cumberbatch received the award for Actor, Miniseries or Movie ('Sherlock: His Last Vow') while Martin Freeman won the award for Supporting Actor, Miniseries or Movie. Neither actor was present to collect their awards
Life and Style
ebooksAn evocation of the conflict through the eyes of those who lived through it
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Client Services Executive / Account Executive - SW London

£23000 - £26000 per annum: Ashdown Group: Account Executive / Client Services ...

PA to CEO / Executive Secretary

£36000 - £38000 per annum: Ashdown Group: Executive PA to CEO & Executive Dire...

Generalist HR Administrator, Tunbridge Wells, Kent - £28,000.

£25000 - £28000 per annum: Ashdown Group: Generalist HR Administrator - Tunbri...

Management Accountant

£30-35k + Excellent Benefits: Guru Careers: We are seeking a Management Accoun...

Day In a Page

Kate Bush, Hammersmith Apollo music review: A preamble, then a coup de théâtre - and suddenly the long wait felt worth it

Kate Bush shows a voice untroubled by time

A preamble, then a coup de théâtre - and suddenly the long wait felt worth it
Robot sheepdog technology could be used to save people from burning buildings

The science of herding is cracked

Mathematical model would allow robots to be programmed to control crowds and save people from burning buildings
Tyrant: Is the world ready for a Middle Eastern 'Dallas'?

This tyrant doesn’t rule

It’s billed as a Middle Eastern ‘Dallas’, so why does Fox’s new drama have a white British star?
Rachael Lander interview: From strung out to playing strings

From strung out to playing strings

Award-winning cellist Rachael Lander’s career was almost destroyed by the alcohol she drank to fight stage fright. Now she’s playing with Elbow and Ellie Goulding
The science of saturated fat: A big fat surprise about nutrition?

A big fat surprise about nutrition?

The science linking saturated fats to heart disease and other health issues has never been sound. Nina Teicholz looks at how governments started advising incorrectly on diets
Emmys 2014 review: Can they genuinely compete with the Oscars

Can they genuinely compete with the Oscars?

The recent Emmy Awards are certainly glamorous, but they can't beat their movie cousins
On the road to nowhere: A Routemaster trip to remember

On the road to nowhere

A Routemaster trip to remember
Hotel India: Mumbai's Taj Mahal Palace leaves its darker days behind

Hotel India

Mumbai's Taj Mahal Palace leaves its darker days behind
10 best pencil cases

Back to school: 10 best pencil cases

Whether it’s their first day at school, uni or a new project, treat the student in your life to some smart stationery
Arsenal vs Besiktas Champions League qualifier: Gunners know battle with Turks is a season-defining fixture

Arsenal know battle with Besiktas is a season-defining fixture

Arsene Wenger admits his below-strength side will have to improve on last week’s show to pass tough test
Pete Jenson: Athletic Bilbao’s locals-only transfer policy shows success does not need to be bought

Pete Jenson: A Different League

Athletic Bilbao’s locals-only transfer policy shows success does not need to be bought
This guitar riff has been voted greatest of all time

The Greatest Guitar Riff of all time

Whole Lotta Votes from Radio 2 listeners
Britain’s superstar ballerina

Britain’s superstar ballerina

Alicia Markova danced... every night of the week and twice on Saturdays
Berlin's Furrie invasion

Berlin's Furrie invasion

2000 fans attended Eurofeurence
‘It was a tidal wave of terror’

‘It was a tidal wave of terror’

Driven to the edge by postpartum psychosis