Serious Money: Some of the most famous names on Wall Street have failed to agree on the significance of bond yields.
Some of my best friends may be economists but one or two of them got very annoyed about the criticisms voiced of their profession in last week's Serious Money.
The point I was trying to make in that article is that economists have nothing practical to offer by way of investment advice when it comes to the most important macroeconomic problem facing global markets today - the US trade deficit.
While accepting that the scale of the problem may be a subject for debate, the consequences for equities, bonds and currencies should not. Even allowing for the usual uncertainties about when the consequences take hold, we should have few doubts about what they are going to be. Instead, we are faced with a debate about whether or not to worry about record balance of payments deficits at all.
My friends moan that this is all too harsh. Economics, they say, was never designed for making short-term investment decisions. Perhaps, but why do banks of all persuasions, particularly investment banks, employ so many of them?
Consider another example. If the US external deficits are the biggest economic problem facing global markets, the relative behaviour of the two main asset classes, equities and bonds, is something of a puzzle. To use Alan Greenspan's terminology, the level of bond yields, particularly of the US variety, presents us with a conundrum. Given all that we think we know about the determinants of bond yields they look far too low.
Are we approaching a consensus about these puzzles? To be fair, I guess that most economists simply believe that bond markets are behaving irrationally and that when sanity is restored bond prices will fall and yields will rise. But there is a large cohort of economists who believe the opposite.
Some of the most famous names on Wall Street are at opposite ends of this debate. Indeed, one of the most well known US economists, Steven Roach of Morgan Stanley, has just had a high profile change of mind, having gone from forecasting doom and gloom, he now expects prices to rise.
Normally, when short-term interest rates rise, courtesy of Alan Greenspan, bond prices fall. This has not been happening during the most recent interest rate cycle. (Full disclosure: I was one of those who thought bonds would suffer in the current environment.) Different economists have different theories. The list of suspects contains familiar and unfamiliar names.
US inflation, one of the biggest drivers of the bond market, has been relatively well behaved, particularly when we think about the behaviour of energy prices, but, at the margin, has not been helpful for bonds. The US government deficit should have been pressuring the bond market - more borrowing means more bonds being issued. The dollar, until recently at least, has been falling, something that also puts pressure on bonds in normal circumstances.
Everyone's favourite plus point for the bond market has been the "mercantilist" behaviour of Asian central banks. They have been buying US bonds with the surplus dollars gained as a result of those huge trade surpluses that they run with America.
If they didn't recycle those dollars in this way their currencies would rise against the dollar, putting pressure on their export sectors thus threatening the economic growth upon which they rely for employment growth. In a sense, goes this argument, the Asians are acting as if they have a permanently fixed exchange rate with the dollar and are acting to prevent this from changing.
As with all similar debates, this one goes round and round. As investors, what are we to make of it all?
Most importantly, should equity investors pay any heed to the extremely low level of bond yields?
The traditional message being sent by bonds is that there is huge trouble in store on the growth front; the only old-fashioned way we can rationalise the behaviour of bond yields is to say that economic growth is going to slump, globally, to the point where a recession is threatened. How likely is this? To be honest, I have no idea - plenty of opinions, but little that I could place much confidence in. Past relationships between economies and bonds seem to have broken down. But bonds are important, not just in their own right but also because most other assets are ultimately priced from them. All individual shares ultimately have a bond yield as a key driver.
One consequence of lower bond yields that is not in dispute is that they act as a kind of monetary stimulus. In the US, for example, low long-term interest rates are keeping the housing market on the boil (US mortgages tend to be more longer term than the variable rate linked products familiar closer to home).
In Europe, the Bundesbank used to lecture us ad nauseum that the economy is more sensitive to longer-term interest rates than anything else - courtesy of low US bond yields and weak growth in Europe, Irish long-term yields are now barely above 3 per cent. With the euro now sliding that represents an awful lot of monetary stimulus for a fully employed economy.
My economist friends seem to think that all of this will be resolved with lower growth - although this is by no means a monolithic consensus. Ever the contrarian, I am not so sure and remain optimistic about growth and equities. But should we despair of the economists? I suppose that if we had given up on physics at the time of Copernicus we would not have made much scientific progress.
Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.
