Chief Editor

There has been much written in the last week about bonds, interest rates and equities - almost too fashionable for me to write about - forever the contrarian! But, as some of what I read was so erroneous I could not resist the urge to cover the subject as this is an important theme whether you are a futures trader, exporter, bond trader, equity investor or even carry a mortgage and you are concerned about where interest rates might head.

Before delving immediately into the finer points, let us look at the basics. In the Australian market, investors are less aware of bonds as is the case in the USA and some other western economies. In other countries, bonds are an integral part of investment portfolios and are much traded by market players. As such their price will reflect "perception" of the economic world and where it is headed. Interest rates are perhaps the greatest determinant in that "perception".

The economic relationship between bonds and interest rates is an opposite one: if interest rates rise or are expected to rise then bond prices fall as the value of that bond, at a fixed rate of interest, has fallen as a better interest rate has now become available.

Interest is a cost in all aspects of running a business - even though you might be debt free in your business - costing of all inputs will be effected indirectly and so that increased cost and therefore reduced profits will be factored in and shares become generally less attractive. This is a précis of what is a very complex economic subject.

Thus bonds and equities move in the same direction over time - that is both in the opposite direction to interest rates. You can see this overall same directional trend in the SFE 10 Yr Bond and SPI 200 monthly chart below. There are periods of divergence, for example 1997-1999, but the overall trend is in a similar direction. Note this is where it is important to choose the appropriate period chart - looking at a daily chart would give you an entirely different perspective

Right now of course equities and bonds are running together but this has only been since March this year which is the first synchronisation since August 2002. The current controversy seems to be that bond and equity prices can't keep rising together like this - the market must make a choice between bonds or equities.

True, but you will also note from the chart that there have been periods where they have run in synchronisation for extended periods but this is unlikely to be the case here. Bonds have some distance to go yet but they are almost reaching a peak and this makes sense from an economic fundamental perspective - there is a limit as to how much further, interest rates can fall - at least in the USA, unless of course they slip into deflation. Further bond price increases and interests rate cuts, small as they might be, appear likely. Whether this is the last of the rate reductions before the next increase will depend very much on the effects this reduction has on the economy.

In Australia, quite a different case exists and with a prevailing strong interest rate differential against the USA rates there is more scope for a reduction. With the Australian dollar strongly climbing without abatement (to US75 cents?) and the likely adverse impact lower exports will have on a slowing economy, one more rate cut appears likely and that should keep bond traders happy for a while as they have already factored in a cut of up to .5%. Our economic masters might think that .5% is a little too risky at a time that requires delicate tuning and it is this uncertainty that will keep markets on tenterhooks for the short term.

Enjoy the ride!

Good trading

Tom Scollon