The value of government stock is as hard to predict as any element of the fluctuating US economy, says Victor Keegan
Wednesday August 6, 2003 The Guardian
For some months, articles in the Wall Street Journal, and elsewhere, have been warning of the danger of a crash in the market for bonds (government stock).
Last week, that sort of crash appeared to have arrived in the UK when Black Friday saw near-panic selling of bonds, driving prices down and, therefore, yields - in effect long term rates - higher.
In recent years, the capital value of bonds has done very well. During the last financial year, they rose by nearly 14%, while shares fell by more than 25%. This is not something that just affects investors in the City. It also affects many ordinary people in the real world.
It means that someone whose pension fund, of the "money purchase" variety, was invested wholly in bonds would have opened up an advantage of almost 40% in the capital value of their fund in a single year, in comparison with someone whose pension money was invested in shares.
Long-term bond yields also influence the housing market, particularly in the US. People can refinance their housing loans if yields drop, thereby boosting the amount of spare money that they have to spend in the shops.
If US consumers spend more, a lot of their extra spending will go on imported goods from Europe.
Traditionally, investors invest in bonds as inflation recedes, especially if the danger of deflation (an actual fall in the price level) appears on the horizon. They go for shares if they fear that inflation or if profits are likely to rise strongly.
Investors who have made the wrong call like to have someone to blame and, at the moment, that someone is Alan Greenspan, the chairman of the US Federal Reserve, who behaved like the Duke of York as he marched bond prices up to the top of the hill and then marched them down again.
By talking up fears of deflation, Mr Greenspan encouraged people to pile into the bond market. The rush into bonds drove down yields, or long-term rates, which is what the Fed wants - cheaper long-term borrowing rates help to fuel economic growth.
Before the Fed's critical meeting in June, investors claim he sent out smoke signals indicating the prospect of deflation was so big that it might have to announce a sharp drop in interest rates at the meeting.
In the event, the cut was only 0.25%, and the Fed indicated that it was not as worried about deflation as people had supposed.
Its remarks acted as a starting pistol for a mass selling of bonds, which promptly dropped in capital value (entailing a rise in their yield).
What happens next? Pessimists believe that bonds will continue to fall in value, but this isn't a forgone conclusion. It could happen for a number of reasons, such as the current US economic expansion outstripping the nation's capacity to supply, thereby triggering a boom to bust syndrome.
However statistics published this week indicate that, at long last, US business is starting to invest substantially in new equipment.
This could provide the extra expansion the economy needs without running out of spare capacity. Of course, if expansion is too rapid, the Fed may have to raise interest rates anyway to cool it down a bit.
None of this makes it any easier to predict what will actually happen to bonds - or indeed to the economy - since the outlook seems to change every other week. The US economy has been defying gravity for so long by expanding, notwithstanding its huge twin deficits (budget and trade), that there is no reason to suppose it will suddenly stop.
If it does go belly-up, there will be no shortage of pundits saying that it was inevitable. But that has not happened yet. Its body may be sick, but its soul goes marching on.
· Victor Keegan is editor of Guardian Online