Relief in sight for bonds

The ill-temper of the world's bond markets receded a little yesterday, but the extreme nervousness continues. It is now being argued in the US (and to some extent in Britain) that the rise in long bond yields may choke off US economic growth - that the growth phase will be cut short by rising fear of inflation.

That implies that the principal reason for the rise in US long-term rates is indeed fear of inflation. But however rational that might seem, it hardly explains why the bond markets took a completely different view of inflation nine months ago, nor why the rise in bond yields has been universal.

The relationship between bond market malaise and the world economy has been one of the main themes discussed at the annual Oxford Analytica/IHT conference this week. At least four explanations for the collapse of bond prices have been advanced, none of them mutually exclusive. There has undoubtedly been some reassessment of inflation prospects, but this can be only one, maybe quite small, part of it.

There has been a rise in commodity prices, but this was mainly driven by the financial markets themselves: money being invested in commodities as a more attractive haven than, er, bonds.

Monetary growth remains subdued, and monetary policy has been tightened by the fall in bond prices. Other warning signs of inflation are not particularly evident. To say that the bond markets are signalling higher inflation may be true, but it is a circular argument to use this as an explanation of the fall: it cannot both be caused by rising inflationary fears and also be a signal of rising inflation.

The other explanations are more interesting. One looks to the cross-border capital flows with Japan. Japan, with its large current account surplus, remains the main saver in the world, and has generally exported those savings by investing in foreign securities, in particular US bonds. This year, however, Japanese investors have largely withdrawn from foreign portfolio investment. The money has to go out somehow and it does so in short-term deposits. But it does not go towards financing the US and other government deficits. So the cost of these rises.

This leads to a third explanation: market indigestion as a result of excessive government deficits. It has been calculated that around pounds 1,000bn of new bonds was issued last year. That is a very big number in relation to the total stock of bonds in issue: 10 per cent more. If lenders could see the prospect of a decline in supply they might be more relaxed, but though deficits are being cut in some OECD countries, they remain suspicious.

Finally there is the overshoot argument: that markets became so carried away last year that they simply went too far. A reaction was inevitable, and was particularly savage because the boom had continued for so long.

We will never be able to attribute precisely the proportion of blame to any of the possible factors. But if one weights the last high in the mix (as I do) it is possible to see a return to more sanguine conditions within the next year or 18 months.

Bear markets in bonds do not last for ever, and much of the adjustment may already have taken place. Provided the central reason for last year's euphoria is intact - that inflation's long-term trend is still down - a year from now the outlook could be much brighter.