Outlook: Trouble looms as bond yields bounce

CONVENTIONAL stock market wisdom has it that shares go up as money gets cheaper, and down as interest rates climb. In other words, bonds and shares move broadly in tandem; when bonds go up, shares do too and visa versa. Typically, the chain of events is that an outbreak of inflationary pressure at the end of a period of expansion will prompt a rise in interest rates, causing liquidity and credit to shrink and investment in shares and financial assets to fall.

Applying this rule of thumb to present circumstances, we should by now be looking at a quite substantial fall in share values on Wall Street. US bond yields have been rising ever since the financial crisis of late last summer. Meanwhile Alan Greenspan, who responded to that crisis with three successive cuts in short term interest rates, has shifted his stance to "a tightening bias".

The yield on the US 30-year bond is more than 6 per cent once more and even the five-year bond isn't far behind. These are the highest levels in more than a year. The last time they were this high, the Dow was trading at little more than 9,000. US shares have been off a bit since early May, but as measured by the Dow, they are still nearly 20 per cent higher than 14 months back.

This can only mean one of two things if the traditional relationship between bonds and shares still counts for anything - either shares are too high or bonds too low. For Wall Street bears, rising bond yields are powerfully indicative of a big correction to come. Something similar happened before the crash of 1987. Some believe history is about to repeat itself.

There are two difficulties with this theory. The first is that the twin engines of shares and bonds actually decoupled some time ago. Throughout the 1980s and most of the 90s the relationship held good, but since July 1997 the correlation has disappeared. As share prices collapsed last autumn, for instance, bond prices soared. Indeed the effect of the recent uptick in bond yields has been to return the yield gap between shares and bonds to more usual levels.

The other big problem is that the rise in longer-term bond yields is in any case a little curious. Normally the phenomenon would indicate a rise in inflationary expectations. This time round, it may not be so. Although most forecasters expect some rise in US inflation, few people expect it to top 3 per cent for the foreseeable future.

So we should perhaps be looking for some other cause for the rise in bond yields. One theory is that they are a simple reflection of growing demand for credit. It obviously makes sense when money is cheap and the economy and stock prices are rising strongly for private companies and individuals to borrow to invest. Simple supply and demand suggests that the more people that do this, the more expensive borrowing is bound to become until eventually the motive for doing it is removed. That point may now be quite close.

However, this too is just a theory, and in these markets one theory is as good as another. The truth of the matter is that nobody has much of a handle on what's going on. What is certainly true is that a profound belief in the virtues of the "new" economy is required to justify valuations at these dizzy heights.

There are new and powerful forces at work in the US economy. Disintermediation (cutting out the middle man) and new technology do genuinely seem to be giving rise to quite substantial gains in corporate productivity. But are they really big enough to sustain stock valuations that collectively amount to a staggering 150 per cent of GDP - far and away the highest ever?

As long as investors accept they are, prices will remain firm. Once their faith begins to falter, then prices will fall.

Over an average lifetime of 70 years, equities are always a fabulous investment, returning round about 8 per cent a year in real terms. This holds good for almost any 70-year period of the last 200 years. But as most people don't start saving until they are old enough to work or later, and stop saving well before they die, not every generation has benefited. Some have been badly caught out by shorter-term vicissitudes of markets.

Since equities have been performing above trend return for more than 20 years now, hugely so over the past decade, we could be approaching one of those difficult, lower return eras. Indeed simple arithmetic tells us that the longer the present period of above average return persists, the deeper the subsequent correction or period of underperformance required to bring the figure back to the average.

It is fashionable for the present generation of retirees to complain about low annuity rates, but the reality is that those buying pensions now are the lucky ones. The savings environment for younger people entering work now is likely to be a lot harsher. Most are going to have to save far more than their parents to earn a similar level of pension in retirement. Thus does one generation pay for the excesses of another.

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