Outlook: Bonds enter uncharted waters

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THE GREAT bull market in equities shows unnerving signs of drawing to a close, but bonds are having none of it. All last week they continued to soar, sending yields to record lows.

It was the same story yesterday as well, with US Treasuries again scaling new peaks. Traditionally equities and bonds move in tandem. so is this not the time to bail out of bonds too? Not a bit of it, says the great bulk of the investment community. Just carry on buying. The way things are going, the yield on US benchmark 30-year Treasuries will be below 5 per cent before the year is out.

The yield gap with equities is closing as never before in recent times. While it still seems unlikely it will close altogether - with the famous reverse yield gap re-reversing to the situation that existed up until the mid-1950s, when equities yielded more than gilts - we are undoubtedly witnessing seismic activity on a level unprecedented in recent history. What's causing it and can it be expected to continue?

There are all sorts of factors at work here, but the most immediate cause of the decoupling that seems to be taking place between bond and equity prices is Asia. The troubles in the rest of the world make American and European assets look profoundly more attractive than they did.

At the same time, however, the economic slowdown caused by the Asia effect is bound to have a depressing influence on corporate earnings, the extent of which is, for the time being, hard to quantify. The natural safe haven in such circumstances is US Treasuries. European bonds come a close second.

With inflation still low by historical standards, shrinking government deficits creating a shortfall of stock, and no other safe havens available, both gilts and US Treasuries are thus prime beneficiaries of the Asia fallout. It is not just Asia, but Russia too. Outside the US and Europe, the whole world seems to be for sale and the proceeds are going straight into US Treasury bonds.

It is this same effect that has driven the dollar and pound higher, with the Japanese yen having now lost an astonishing 75 per cent of its value against the dollar in three years. It would be hard to imagine a more vivid or decisive judgement on the relative strengths of the Japanese and US economies.

Is this necessarily good news for those of us in the Western orbit? Probably not, for although it still seems unlikely that Japan and the Far East will pull us down with them into quite the same vicious circle of deflationary despair, we may be more profoundly affected than we thought. And if that's the case, bond yields will just carry on falling and falling.

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