"Me, Crockett and Tubbs"

There was a terrible moment the other day when I felt like I had been transported back to the 1980s; not that I was experiencing my soberclothes turning a lurid Day Glow or for that matter the sleeves of my carefully tailored suit riding up a la Crockett and Tubbs in Miami Vice orindeed my, by necessity, respectably coiffured hair descending into an unruly "Mulle". No, there was a sudden spat of people talking and writing about money supply which was a decidedly 1980s phenomenon. The thing that triggered it was the release of the UK broad money supply numbers that showed borrowing was growing at the kind of rate not seen for 20 years.

Back then this set off unimaginable inflation as too much money chased too few assets (houses, video players, Italian suits, that sort of thing). But what struck me is that two things can look the same, have a vague relationship with the past but actually be totally different. Take for instance, these two pictures of me. They are ostensibly the same person; they look sort of similar there are one or two distinguishable points of connection, but the passage of time has made them utterly different and you shouldn't expect them to have the same effect on the world. I was, for instance, much more sensible then.

The key to our new relationship with money supply is that, back then, there were just too few goods. These days we are deluged with cheap imports from around the world and far from causing prices to rise, more money makes producers compete for our attention by lowering prices (the exception is houses because they are in finite supply).

So if inflation isn't showing up in traditional places then where is it? The answer is pretty simple - it is inflating financial assets. Bonds, stocks, specific currencies, commodities, real estate etc. to levels that are difficult to fathom if your sensibilities are rooted in the 1980s, that is. Part of the problem is that economic rationality (a very 1980s phenomenon), the idea that every transaction in society can be reduced to the behaviour of sentient beings in command of all of the facts all of the time, has been supplanted by numbers.If the numbers work, investors will now do things that make no sense whatsoever if you just weighed up the economics of the world.

Take, for instance, the recent rally in bonds. You can wrap a nice neat economic argument around it relating to the slow down in US housing and economic activity but there are also other forces at work. There is the so called "carry trade" which consists, for the Japanese at least, of borrowing money at a negligible cost then buying higher yielding foreign bonds.There is a foreign exchange risk involved but even this can be mitigated by hedging. So if you looked at the raw situation around the global bond markets it would look like the first graph. If you took hedging costs into account then it would look like the second graph.

Clearly the best thing to buy is US long-dated assets because they yield more than the equivalent yen based assets by about 0.75% even when you have taken out the foreign exchange risks. Repeat this calculation (not shown here for space reasons) and no matter your currency base (sterling, US dollars or euros) you get the same answer - buy long-dated US bonds.

This is an important result. There are many people with different motivations and investment philosophies that use the financial markets and using economics alone is not sufficient to prove everything all the time. Actuaries and hedge fund managers may merely look at their numbers and buy things that make no sense to an economist purely because the numbers work for them. Despite their different risk profiles,these two user groups are united in the fact they are concerned with some shorter-term market movements and because the sheer volume of money they are responsible for can have disproportionate effects. It has been noticeable that the broker community has responded to this byre orientating their research to portfolio positioning as a driver of their forecasts. As asset managers we are left with the unenviable task of not only guessing the themes and fundamental drivers of the markets, but also second guessing the positioning of others to correctly divine the next big moves in bonds and currencies.

Right now, the maths works for bond investing. The record US$117bn of net purchase of US securities by foreigners in August tells us that mathematics is a powerful motivation compared to what we fundamentally know about the US. But equally, the effect can operate in reverse when the maths stops working. Right now we can see why the economics could overtake the numbers in the coming months sending bond yields lower but, at the same time, the economic effects that the US dollar has so far escaped (growing budget deficit, trade deficit etc) should stop working and the day of reckoning will be upon it.