Stocks, bonds and gold

Buttonwood: Squaring the circle | The Economist

The real reason why all three asset classes have been rising is simply down to liquidity. Low interest rates are driving investors out of cash and into anything that offers either the prospect of capital gain or a yield that is higher than zero. Investors used to talk about a “Greenspan put” that supported the stockmarket. This time there is a “Bernanke put” supporting all asset prices.

How long can this last? The authorities are inflating the value of “financial wealth” relative to “real wealth”—goods, services and the businesses that produce them. Real wealth has undoubtedly taken a hit. Industrial production in most OECD countries is still showing a double-digit percentage decline year on year.

A policy of bolstering asset prices can work for a while but eventually it leads to tensions and distortions. The problem could show up in the currency markets, where America has been getting a free ride, running a big fiscal deficit with zero interest rates and a depreciating currency. Other countries are feeling the pressure. Brazil is imposing a 2% tax on portfolio inflows in an effort to slow the real’s rise. An adviser to the French president describes a rate of $1.50 to the euro as a “disaster”.

Another possibility is that the authorities see the market rally as evidence of success and withdraw their fiscal-stimulus packages too quickly. The shift is already under way in Europe.

If the trifecta does break down, then the consensus favours government bonds as the asset class to suffer. But is that the right call? After all, 20 years into their crisis, and with gross government debt heading for 200% of GDP, Japanese bonds yield just 1.3%. Perhaps ten-year Treasury bond yields of 3.4% are reasonable after all. Headline inflation is still negative, so in real terms yields are strongly positive. In addition bond yields can be seen as the weighted average expectation for the future level of short rates. Since the Federal Reserve has made it clear that short rates will be kept low for a considerable period, that drags bond yields down. Market expectations for bond yields in five years’ time are around 4.5%, within the range in which bonds traded for much of this decade.

The only other times the three-way bet worked were back in the early 1980s. On each occasion when it broke down, the casualties were equities and the gold price as the economy slipped into a double-dip recession. It could happen again.

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