The strange meltdown in financial markets

The gradual meltdown in financial asset prices in the past few weeks has been something of an oddity. Clearly, the bond markets have led the stock markets down, but the slide in bond prices has occurred without any obvious trigger from the fundamental economic forces that normally shape sentiment.

Admittedly, the decision of the Federal Reserve to increase interest rates by a quarter-point on 4 February could be seen as the trigger. But the reaction has been rather extreme. Since the Fed's announcement, the yields on 10-year bonds around the world have generally risen by 0.5- 0.75 per cent - the bond equivalent to a large earthquake.

The standard explanation for this is that 'speculative' investors, including the so-called 'hedge funds', had become heavily over- invested in bonds (especially European bonds) by the early part of this year, and that the sell-off has been caused by a stampede among these investors to close their positions. On this view, the behaviour of mobile short-term investors (let us call them the 'hedge funds' for short) have exacerbated both the upward and downward movements in markets in the past year, greatly adding to the volatility of asset prices.

Certainly, the hedge funds and their kindred spirits have access to much greater capital resources today than ever before. Several of the older funds have generated annual rates of return of between 50 and 70 per cent for several years, which alone has hugely increased their financial muscle. Furthermore, new funds have been swamped by money from investors fleeing from 3 per cent returns on American cash.

But the main reason for the power of the hedge funds is that (unlike many investors) they are able to use 'leverage' to maximum effect. For example, a hedge fund with dollars 1bn of investors' capital might borrow enough money to hold bonds worth dollars 10bn. If bond prices rise 10 per cent, the hedge fund doubles its money; but if bond prices fall by 10 per cent, the hedge fund is wiped out. Obviously, a global bull market in financial assets can, for a time, produce hugely flattering returns to anyone who adopts this strategy.

Many of the older hedge funds are managed by some of the most astute traders in the world today. Their risks are carefully controlled, and they will probably continue to provide a useful service to some categories of investor in any future market conditions. But it is hard to avoid the suspicion that the sudden explosion in new funds in recent months has been driven by the same mania for 'leverage' that has characterised bull markets since time immemorial. And it would also be normal for some extreme pain to be suffered as investors once agin learn the time-honoured lesson that leverage does not always pay.

Quite often in the past (in October 1987, for example), the deleveraging process has caused a severe crash in asset prices. So far on this occasion, the process has been much more controlled. Nevertheless, central banks are said to be worried that they do not have enough information to monitor the hedge funds, especially in the derivative markets which are not fully regulated. There have been reports that the central banks will try to reduce the 'funding' available to hedge funds, forcing them to hold smaller positions, with much less leverage.

If this is the intention of central banks, they will need to be cautious about introducing such a policy, since it could initially cause a further collapse in asset prices as the hedge funds are forced to liquidate positions to reduce leverage.

No doubt central banks are aware of this risk, but they have been eagerly awaiting an opportunity to curtail leverage for some time, and a move in this direction, perhaps accompanied by temporary cuts in short-term interest rates in some countries, is a possibility.

In the longer term, the behaviour of the financial markets will presumably return to more normal conditions, in which fundamental value will re-assert itself. Fortunately - and this is the key reason the deleveraging process has not been as painful as it was in 1987 - most of the financial markets do not seem to be priced particularly expensively relative to normal. This mitigates the chances of a serious crash, since it means that long-term investors will tend to step in with purchases if the more 'speculative' players become heavy sellers.

The table shows some snapshot valuations of bonds and equities relative to inflation and short-term interest rates. First, let us consider the bond markets. In order to be persuaded to hold a 10-year bond, as opposed to a shorter dated instrument, the investor must believe that being locked into long term debt will produce a better return than leaving cash in the money markets - a strategy that would maximise flexibility.

Under normal circumstances, long bonds must therefore offer a higher yield than the expectation of cash returns (ie successive short- term interest rates) over the life of the bond. Consequently, one way of valuing bonds is simply to take their yield relative to current short rates. And, since the market's expectations of short rates are undoubtedly related to inflation expectations, it is also important to value bonds against expected inflation. This involves an inspection of real bond yields.

Real bond yields in the important markets vary from 2.8 per cent in Japan to 4.9 per cent in France. Compared with previous cycles, these yields look about right in the US, quite high in the UK and France, and somewhat low in Japan and Germany. In other words, it is a mixed bag, but with little sign of a chronically overvalued bond market on a global basis.

Relative to current short rates, the US and Japanese markets seem to offer outstanding value, the UK gilt market is about right, and the continental European markets look extremely expensive. This offers a fundamental clue to what has been happening recently in the European markets.

As the European recession deepened, the markets became convinced that there would be huge cuts in short-term interest rates, led by the Bundesbank, but so far these have not been fully forthcoming.

From now on, we must either get further cuts in European short rates, or bond yields on the Continent will continue to rise, thus slowing the recovery from recession. Faced with this unintended tightening in policy caused by the bond markets, the Bundesbank will surely reduce short rates again soon. (Either way, though, the European yield curves must certainly steepen, so that bond investors receive enhanced returns relative to cash.)

Finally, equities. At present, all the large stock markets (except Germany) look cheap relative to short rates, and none is chronically overvalued against bonds. This situation stands in sharp contrast to October 1987, when equities were massively overvalued relative to both bonds and cash. With the world economy now recovering, a global equity crash is not the most probable outcome. But if it does happen, get ready to empty the building society to buy stock.

(Table omitted)

Start your day with The Independent, sign up for daily news emails
Arts and Entertainment
Buttoned up: Ryan Reynolds with Helen Mirren in ‘Woman in Gold’
filmFor every box-office smash in his Hollywood career, there's always been a misconceived let-down. Now he says it's time for a reboot
News
people
News
Actress Julianne Moore wins the Best Actress in a Leading Role Award for 'Still Alice' during the 87th Annual Academy Awards in Hollywood, California
people
Sport
Ross Barkley
footballPaul Scholes says it's time for the Everton playmaker to step up and seize the England No 10 shirt
News
'We will fix it': mice in the 1970s children’s programme Bagpuss
science
Life and Style
2 Karl Lagerfeld and Choupette
fashion
ebooks
ebooksA special investigation by Andy McSmith
  • Get to the point
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

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

iJobs Job Widget
iJobs Money & Business

SThree: Graduate Recruitment Resourcer

£20000 per annum + commission: SThree: Sthree have an exciting opportunity for...

Recruitment Genius: Telesales Executive - OTE £32,000+

£18000 - £32000 per annum: Recruitment Genius: A Telesales Executive is requir...

Ashdown Group: Marketing Manager - B2B, Corporate - City, London

£45000 - £50000 per annum + benefits : Ashdown Group: A highly successful, glo...

Neil Pavier: Commercial Analyst

£50,000 - £55,000: Neil Pavier: Are you a professionally qualified commercial ...

Day In a Page

War with Isis: Iraq declares victory in the battle for Tikrit - but militants make make ominous advances in neighbouring Syria's capital

War with Isis

Iraq declares victory in the battle for Tikrit - but militants make make ominous advances in neighbouring Syria
Scientists develop mechanical spring-loaded leg brace to improve walking

A spring in your step?

Scientists develop mechanical leg brace to help take a load off
Peter Ackroyd on Alfred Hitchcock: How London shaped the director's art and obsessions

Peter Ackroyd on Alfred Hitchcock

Ackroyd has devoted his literary career to chronicling the capital and its characters. He tells John Walsh why he chose the master of suspense as his latest subject
Ryan Reynolds interview: The actor is branching out with Nazi art-theft drama Woman in Gold

Ryan Reynolds branches out in Woman in Gold

For every box-office smash in Ryan Reynolds' Hollywood career, there's always been a misconceived let-down. It's time for a rethink and a reboot, the actor tells James Mottram
Why Robin Williams safeguarded himself against a morbid trend in advertising

Stars safeguard against morbid advertising

As film-makers and advertisers make increasing posthumous use of celebrities' images, some stars are finding new ways of ensuring that they rest in peace
The UK horticulture industry is facing a skills crisis - but Great Dixter aims to change all that

UK horticulture industry facing skills crisis

Great Dixter manor house in East Sussex is encouraging people to work in the industry by offering three scholarships a year to students, as well as generous placements
Hack Circus aims to turn the rule-abiding approach of TED talks on its head

Hack Circus: Technology, art and learning

Hack Circus aims to turn the rule-abiding approach of TED talks on its head. Rhodri Marsden meets mistress of ceremonies Leila Johnston
Sevenoaks is split over much-delayed decision on controversial grammar school annexe

Sevenoaks split over grammar school annexe

If Weald of Kent Grammar School is given the go-ahead for an annexe in leafy Sevenoaks, it will be the first selective state school to open in 50 years
10 best compact cameras

A look through the lens: 10 best compact cameras

If your smartphone won’t quite cut it, it’s time to invest in a new portable gadget
Paul Scholes column: Ross Barkley played well against Italy but he must build on that. His time to step up and seize that England No 10 shirt is now

Paul Scholes column

Ross Barkley played well against Italy but he must build on that. His time to step up and seize that England No 10 shirt is now
Why Michael Carrick is still proving an enigma for England

Why Carrick is still proving an enigma for England

Manchester United's talented midfielder has played international football for almost 14 years yet, frustratingly, has won only 32 caps, says Sam Wallace
Tracey Neville: The netball coach who is just as busy as her brothers, Gary and Phil

Tracey Neville is just as busy as her brothers, Gary and Phil

The former player on how she is finding time to coach both Manchester Thunder in the Superleague and England in this year's World Cup
General Election 2015: The masterminds behind the scenes

The masterminds behind the election

How do you get your party leader to embrace a message and then stick to it? By employing these people
Machine Gun America: The amusement park where teenagers go to shoot a huge range of automatic weapons

Machine Gun America

The amusement park where teenagers go to shoot a huge range of automatic weapons
The ethics of pet food: Why are we are so selective in how we show animals our love?

The ethics of pet food

Why are we are so selective in how we show animals our love?