On both sides of the Atlantic bond prices are falling, which means government borrowing rates are going up. In the US we know the Fed wants to wean the economy off ultra-low rates, and might make a move once the Presidential election is out of the way.
In the UK, the weak sterling many have been forecasting is leading bond markets to doubt the Governor of the Bank’s idea of any more quantitative easing or a further interest rate cut. Maybe the pound needs the protection of interest rates more like US ones if it is to stabilise. The bond market seems to think so and is narrowing the gap between UK and US yields.
In the Euro area some commentators think they are running out of sovereign bonds to buy under their current rules, making some nervous about whether the European Central Bank may have to scale back its buying programme. Euro area yields are tiny or negative, and only sustained by continued Central Bank buying.
There could be a bit more inflation in prospect in the year ahead, which encourages people to sell fixed income bonds more. In the UK in particular there will be price rises from the higher cost of imports, as the effects of lower sterling work through. The rise in oil prices will also provide a modest upward pressure on global inflation as well.
These developments are not necessarily negative for shares. If output and revenues expand dividends can go up to offset the impact of inflation. We have favoured shares more than bonds in recent months, and these events reinforce that preference.
The Bank of England is nervous in the UK case that the increase in prices could cut into real incomes, damaging confidence and consumer spending. So far the consumer has been willing to increase spending since the referendum, but we will watch carefully for any signs of adverse change. The Bank is also concerned about investment by large companies.
Some have been unsettled by recent events, but others who see market opportunity have announced expansion programmes, leaving the position mixed. UK shares have rebounded strongly since the referendum result, and have hit new highs. They are no longer cheap. There are UK-specific risks from here, given the continuing scale of both the state deficit and the balance of payments deficit, and the market’s uncertainty over future monetary and trade policy.
It is true that quantitative easing programmes boost share prices as well as bond values. In Japan the Central Bank is doing this directly by buying shares as well as bonds with its newly created money. In the Euro area and the UK, the impact is indirect.
Portfolio investors who sell the bonds to the Central Bank are likely to reinvest the money in shares, helping drive up the market generally. All of the time it continues it will offer some support to shares as well as to bonds. Conversely, if we are now going to witness an increase in interest rates in the US, and if the UK stops special measures at the end of its current short programme, this removes important financial support from asset prices.
Markets have had a good run so far this year. There is plenty they can worry about, from the US election, through the situation in the Middle East, to the state of European policy on both sides of the Channel. The next few weeks will provide some of the answers, against the likelihood of a wobbly background in markets.
It does not look, however, as if any of the main advanced country authorities want to suddenly remove all monetary support, as they realise that would have a large negative impact, and not just on share and bond markets, but also on the wider economy.
John Redwood is Charles Stanley’s Chief Global Strategist.