Secrets Of Success: Bonds are the best fortune-tellers

I'm not sure how much time readers spend thinking about the state of the global bond markets. In reality, they are every bit as important as stock markets, being bigger in size and a more immediate and reliable barometer of the mood of investors and the economic future as perceived by the professional investment community.

I'm not sure how much time readers spend thinking about the state of the global bond markets. In reality, they are every bit as important as stock markets, being bigger in size and a more immediate and reliable barometer of the mood of investors and the economic future as perceived by the professional investment community.

Rising bond yields are typically an indicator of higher inflation ahead, and therefore often associated with stronger growth in the economy. Falling bond yields, though they signal that the risk of inflation is receding, may also be a warning that economies are about to slow down or even drop into recession.

The shape of the yield curve - the way that short-term bond yields relate to longer-term yields - adds a further dimension to this picture. It is arguably one of the most important single indicators that investors need to watch.

When the yield curve starts to flatten or decline - when short-term bond yields are rising relative to long-term yields - it is often a sign of trouble ahead. When it is upward sloping, the yield curve is good for bank profits and thus the availability of credit, and is what you typically see during periods of faster growth.

So far, so good. Interpreting what is happening in bond markets, relatively simple though it may seem, is no easy matter, however. As in all markets, it is unusual to find much of a professional consensus about what current bond prices and yields foretell. An army of analysts is paid to call the direction of bond markets, but they are as regularly confounded by the turn of events, at least in the short term, as professional equity investors.

What is unusual about the present state of play in the bond markets is that even the market's moving spirit, Alan Greenspan, the chairman of the Federal Reserve, appears to be uncertain about what is happening. Since it has the ability to move short-term interest rates, the Fed has considerable power to influence both the mood of the market and the direction and shape of longer-term bond yields. But influence is all that the chairman can provide: the markets themselves ultimately decide.

Twice in recent months Greenspan has talked publicly about the "conundrum" of current government bond yields. In particular, he has noted the curious phenomenon that has resulted in bond yields staying so stubbornly low, despite the Fed making nine increases in short-term interest rates since 2003.

The yield curve is still facing upwards, though not by much. This too has puzzled many serious professional investors as well, not least Warren Buffett. He commented at his annual meeting this year that, had he known in advance everything the Fed was going to do over the past two years, he would never have predicted that 10-year government bond yields would still be as low as they are.

Opinion about whether bond yields are going to rise, fall further or stay where they are continues to yo-yo. The other day, Bill Gross, whose firm Pimco is generally reckoned to be the world's leading bond fund firm, announce to his followers that he now expects bond yields to remain subdued over the next three to five years, trading in the 3 to 4.5 per cent range. This from a man who only a few months ago was sharply reining in the "duration" (or interest rate risk) of his bond fund portfolios in order to protect his investors against further rises in both interest rates and bond yields.

This is an interesting change of tune, and one that has clearly caused Gross misgivings. Interested readers can follow some of his arguments for themselves by going to www.pimco.com and looking for his commentary piece "The Strange Tale of the Bare-Bottomed King". They will find that he remains worried about the imbalances in the world economy and the fact that global economic growth is being kept going by the debt-driven asset price bubbles in the US.

He questions how much longer what he calls "the pump" - the injection of demand into the global economy prompted by artificially low US interest rates - can continue. Real yields, as represented by US inflation-linked bonds, have already fallen from 4 per cent to 1 per cent and cannot realistically fall below 0 per cent.

If he is right about the future path of bond yields, it will have some important implications for investors. The presumption is that it means inflation is not on the way back up (Gross thinks that 3 per cent inflation is the very limit, and it could be less).

Some of the asset price bubbles of the past few years could continue a while yet. That, one would think, would also be broadly positive for equities (it has to be said that the same Mr Gross predicted a couple of years back that the US stock market could easily halve, underlining how opinions change in the professional community).

It would also mean it was relatively safe to go on holding government bonds, but that bonus rates on many pension fund and life company policies, largely set by the level of bond yields, will remain subdued.

The broader question remains how the world is going to redress the global imbalances that have resulted in the yawning US current account deficit and the unprecedented accumulation of dollar reserves by Asian countries. It is unsustainable, and the bond markets know it, but nobody yet has a clear vision of how the imbalances might come to an end.

What you can be sure about is that opinion in the bond markets will continue to fluctuate. Bond investors are paid to worry, and it is safe to assume that they will go on doing so, not least because the risk of some kind of financial/economic accident remains.

jd@intelligent-investor.co.uk