"The United States of Asia"

It's been difficult to put pen to paper over the past couple of weeks because just at the moment when one thought the markets were settling down another leg up in yields occurs (fall in prices) which makes your piercing perspectives instantaneously redundant. Fortunately, we have been running a very low duration on our global bond funds during this time (around about 2 units of modified duration compared to a market index of around 6) which has saved our clients from the ravages of the markets that has seen the U.S. long bond decline by a full 8.7% in capital terms (see illustration). Frankly, it's not the sort of losses expected of bonds - you would normally have to look at the equities for that kind of capital risk.

I suppose, to our credit, what we have latched onto here is two things:

There has been the added influence that louder and more influential voices (see Bill Gross at PIMCO, who runs the biggest bond fund in the world, for details) have made clear their opinion that we are entering a new era which would see inflation back on the agenda (maybe not tomorrow but strategically going forwards) in a way that we had learned to disregard over the past seven years. For instance, we certainly concur, through our own modelling process, that bond yields in the U.S., in particular, are about 0.5% too low on purely economic terms in recent times merely because demand for bonds exceeded supply. It comes as no surprise to us that, in the absence of an outright recession, some form of correction was inevitable hence our low duration strategy over the past couple of months.

However, we have been here before. Over the past four years the bond markets have traded in a fairly tight yield range of about 1%, top to bottom, and the possibility of this current rout being just another one of those mini-cycles seems to be the stuff of The Great Moderation. But there are some new things that we would like to draw your attention to.

First of all, the reorganisation of reserve assets is proceeding at a rapid pace (in China, Japan and the Middle East), and is distinctly anti-bond, pro-equity and anti-US dollar in nature. Can it really be any coincidence then that the last 10-year maturity bond auction in the U.S. was 87.5% sold to dealers rather than real end-users for instance? Taken forwards, can you imagine what an unfunded U.S., starved of foreign capital, would look like unless the indigenous institutions took up the slack? It is too scary to think of. The U.S. dollar would fall to pieces in the face of a wall of indifference and, if financial theory is anything to have any regard for, yields would have to rise to attract investors. This, in microcosm, is sort of what happened recently.

But, as we have pointed out in these pages in the past, this scenario is in nobody's interests. Certainly, the U.S. consumer needs to be patronised by the Chinese until their indigenous population is in the position to take over as the most powerful economic group in the world. It came as no surprise then when we heard a market rumour that the Chinese had purchased several billion dollars worth of long-dated debt in the U.S. in order to try and stand in the way of the rising yields that would harm their main customer.

This sets up an intriguing idea: the U.S. Federal Reserve no longer runs the U.S. economy - The People's Republic of China does since they are the buyers of bonds as a last resort (because they have the money) and it is, after all, long-dated bonds that controls mortgage rates and thereby disposable income in the U.S.

With all of these vested interests in a stand-off at play, the rise in bond yields is, for now, a self-limiting process. But we have been given a taste of the future. When (not if) Asia starts exporting inflation, and they choose to redeploy their capital elsewhere other than the U.S., the western hemisphere, as the maps currently view it, is in big trouble and whereas we have been bond managers who have been fundamentally "long", the bond markets going tactically "short" from time to time, we will be converted into investors who will be fundamentally "short", the bond markets going tactically "long" from time to time. We are not calling, yet, for the end of the great secular decline in bond yields but we can see the end game and what it might look like.