Bonds… another bubble waiting to burst

When he was in Brussels in January, Larry Summers, who was the last treasury secretary in US president Bill Clinton’s administration, told me that there were some risks connected with the economic policy prescriptions that he had been advocating for America.

His recommendations - that the Federal Reserve, the US central bank, slash interest rates and that President George W. Bush and the Congress agree on a significant budget stimulus - could trigger a new asset bubble. But, he said, this was a judgement call. Given the scale of the problems that the US faced, his view was that this was a risk worth taking.

The Fed and Bush duly did as Summers wanted. The Fed sent its policy interest rate plunging to 3% on 30 January, down from 4.25% at the beginning of the year, and US politicians agreed on a $152 billion fiscal stimulus package last week.

Last week, Jean-Claude Trichet, president of the European Central Bank (ECB), indicated that he and his colleagues had no intention of following the Fed’s dramatic lead. At his press conference after the ECB Council meeting (7 February), Trichet merely fine-tuned his public statements. He cut out the (barely credible) threat that the next ECB rate move might be upwards and opened the door to the possibility of a rate-cut some time in the future.

But are worries about another asset bubble the least bit credible when the world economy is slowing and the US (on recent evidence) is either entering recession or growing (in 2007’s fourth quarter) at an annual rate of a meagre 0.6%, the stock market is fragile and housing markets, in the US and the several EU countries, are crumbling?

The answer is that there is one potential ‘bubble’ which has yet to burst - the bond market. The prices of fixed-interest bonds would crash if inflation were to get still worse.

On 5 February, the Organisation for Economic Co-operation and Development (OECD), the rich countries’ think-tank, published its December inflation figures for its members. These showed an annual rate of inflation of 3.3%. In the US, the OECD said, the consumer price index hit 4.1%, just about the rate, incident-ally, at which Republican President Richard Nixon introduced price and wage controls in 1971. In the eurozone, the harmonised index of consumer prices rose in December at 3.1%, uncomfortably, to put it mildly, above the ECB target of 2%. Neville Hill, an economist at Credit Suisse in London, says that eurozone inflation may not fall to 2.6% until September. There is plenty of evidence, he says, that, once it sets in, euro-inflation tends to be persistent.

Marco Annunziata, a UniCredit economist, was warning as early as July of last year, in a fascinating research paper, that EU inflation risks would be tilted to the upside for much longer than markets expected. "Inflation," he said, "should be analysed more as a global, not a regional, phenomenon."

He also believes that rather than higher wages driving inflation upwards, it is inflation that drives up wages. So the ECB is right to be worried about inflation expectations.

At the moment, judging from both actual and inflation-adjusted interest rates, the markets are still expecting inflation to decline. Ten-year bond yields in the US are 3.68%. That is actually below the current rate of inflation. Even in the eurozone, ten-year bond rates, at 3.9%, yield less than 1% above inflation, a historically unsustainabe level unless inflation falls back to below 2%.

Annunziata said in July that "if investors were to suddenly up their inflation expectations, fearing that central banks might be behind [the anti-inflationary] curve, this would have a seriously disruptive effect on markets".

Now we are in the middle of a protracted credit market crisis with banks wondering just how tough conditions are going to get. So it is not hard to imagine just how disruptive a sudden jump in US ten-year bond yields, to say 5%, in response to much gloomier inflation expectations, might be.

After the Fed’s rate cuts and the fiscal stimulus, US economic policy is on a knife-edge. Bond investors are betting on the best of all possible outcomes, namely that inflation will fall quickly even though the economic slowdown is quite shallow. And, as growth recovers later this year, they are hoping that the Fed will move swiftly (irrespective of the presidential election) to raise rates and curb any incipient inflationary pressures. And pigs may fly.

The ECB should (and will) be far more wary than its Washington counterpart. It will not cut rates significantly until either it is confident that inflation is really coming under control or signs of a serious economic slowdown are unmistakable. Indeed, if inflation really is a global phenomenon, Washington’s economic policy stimulus may make the ECB more cautious.

Better that Europe suffers a mild recession than that the markets start to believe that the ECB is prepared to tolerate inflation above 3% indefinitely and see bond market prices collapse. The destructive impact that a punctured bond market bubble would have on asset values and confidence in already punch-drunk financial markets does not bear thinking about.

• Stewart Fleming is a freelance journalist based in Brussels.

When he was in Brussels in January, Larry Summers, who was the last treasury secretary in US president Bill Clinton’s administration, told me that there were some risks connected with the economic policy prescriptions that he had been advocating for America.