Rising bond yields a risk to property bubble

Serious Money: If one of the most important determinants of all asset prices is, and always has been, the humble bond yield, the new world that we live in means that it is to China that we must look for the likely drivers of bond markets over the foreseeable future.

Bonds ultimately determine everything. It was, I think, James Carville who said: "I used to think, if there was reincarnation, I wanted to come back as the president or the Pope or a .400 baseball hitter, but now I want to come back as the bond market. You can intimidate everybody."

Spoken when he was a key member of the Clinton administration, this somewhat bitter reflection on the importance of the bond market arose because of the power those markets were thought to hold over economic policy. It was the bond market that largely forced Bill Clinton to become a fiscal conservative. It was the bond market that held in check the wilder flights of fancy of many a politician.

US President George W Bush would not agree, of course. Bonds have not prevented him from embarking on an unprecedented tax-cutting spree that has completely undone all the fiscal probity of Clinton. It is ironic that a supposedly conservative Republican has negated all the good work done by a Democrat, one who is, to this day, despised by neo-conservatives as suspect in all things, including finance and economics.

If bonds were an effective constraint on Clinton, how come they have not prevented a free-spending president from wrecking US public finances? The answer, in part, lies with the voracious Chinese appetite for US treasury securities (the most important bond market).

Alan Greenspan described it as a conundrum, but his puzzlement over the behaviour of the bond market was largely a coded way of saying that he couldn't believe how treasury investors had allowed Bush to get away with it. Greenspan's successor as chairman of the Federal Reserve, Ben Bernanke, thinks he has squared the circle with his identification of a global surplus of saving - the largest part belonging to China - that buys bonds no matter what.

At their low point in June of last year, US 10-year treasuries yielded 3.88 per cent. The US government, in the middle of one of the largest fiscal blow-outs in history, could borrow from investors, like the Chinese, at a rate that was unprecedented in modern times. Notwithstanding Bernanke's explanation, I'm not sure that we will ever understand why yields fell so low. Bonds may be exceptionally unexciting but they seem to be as prone to over-valuation as technology stocks.

If anyone thought that bond yields of 4 per cent were likely to be sustainable then equities were an absolute "steal". That's because all valuation methods for stocks ultimately depend on the bond yield: use as many simple or fancy ratios as you like, there is no sensible valuation technique yet invented that does not depend, somewhere along the line, on the yield on government securities. The lower the bond yield, the higher equity prices can go. That the US stock market did not embark on another of its stratospheric rises is in no small part due to most investors knowing full well that bond yields of 4 per cent were not going to be around for long.

Bond yields have subsequently risen to 5 per cent. This has given rise to one or two equity market wobbles, but nothing too serious (as yet anyway), mostly because equities never managed to price themselves off the temporarily low level of yields that prevailed in the middle of last year. Sadly, we can never know with certainty precisely what yield is being priced into stocks, but my own hunch is that even 5 per cent is too low; equities believe that the "correct" yield is higher than that.

How much higher is tough to say, but I sense that, ultimately, it will take a 10-year yield above 5½ per cent to cause any serious concerns.

Yields are rising for a number of reasons. They were too low and, therefore, had to rise whatever the economic environment. And, as it turns out, the US and global economies are not exactly bond friendly at the moment. Growth is very strong, inflation is edging up and central banks are raising short-term interest rates. Given all of this, it is possible to marvel at how restrained bond market behaviour has been.

It's not just equities that depend on bonds. For all the analysis of the global property boom, one factor is often ignored. The next time you listen to an analyst droning on about supply and demand factors that will keep Irish property prices high forever, ask him what he thinks about bond yields.

These long-term interest rates are just as important a determinant of real estate values: if there was one market that did start to price off ultra-low yields, it was the property market. Hence, this market, rather than the stock market, is the one most vulnerable to the rises in yields that we have already seen and the one that could suffer the most if bond prices continue to fall further.

The Chinese, and others, have been buying US bonds because they have to. That could change - they could decide to buy Italian bonds, stamps or good claret instead, but I doubt it. But the one thing that could drive bond yields even higher, notwithstanding Chinese demand, is global growth. And, of course, China is a big part of that story as well. News that the Chinese economy accelerated in the first quarter - contrary to all forecasts - is not helpful for bonds.

Higher bond yields will, I believe, be a bigger negative, ultimately, for property than it will for stocks. There is no bubble in equity valuations. If only that was true for real estate.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.