Economics Dan McLaughlinFinancial markets tend to be rational, particularly in the long run, but at times they are as prone to following fads, fashion and the herd as the rest of us.
The dotcom "bubble" is a recent example of this type of behaviour, when equity valuations on tech stocks moved to levels which stretched to the breaking point of most conventional valuations models.
Some analysts pointed this out, of course, but many at the time were eventually fired for being wrong, and it is probably small consolation to them now that the market eventually returned to more realistic values.
Right now, there is another possible example of this irrational behaviour in the bond and equity markets, although there are plenty of analysts willing to contest that view.
The issue is the low level of bond yields, which US Federal Reserve chairman Alan Greenspan recently referred to as a "conundrum"; US 10-year yields are lower now than when the Fed started to raise short-term rates a year ago, and the Government can borrow money for 10 years at an annual interest rate of only 3.35 per cent.
Moreover, demand from investors has been very strong, even at such historically low-yield levels, with pension funds shifting out of equities into bonds - one estimate is that in the UK alone, some €40 billion was moved from stocks into bonds in 2004. Low long-term interest rates are normally positive for equities, but such is the preference for bonds that most stocks are now trading at valuations which would be generally considered as cheap.
The dividend yield on the two larger Irish banks, for example, is above the yield on 10-year bonds, so an investor would get a higher return on the stocks, even if there was no price appreciation.
Equity prices can and do fall, of course, so one explanation is that investors have become more risk-adverse, particularly in the wake of the three-year bear market in stocks, which began in 2001. Yet the cost of raising funds for borrowers normally considered high-risk - Latin American governments for example - has also never been lower, implying that risk aversion alone is not the answer.
There are two other plausible explanations, one economic, the other relating to regulatory and accounting changes. The economic rationale given is that markets have decided that inflation is a thing of the past and that central banks will always be ahead of the game, so that short-term interest rates will not have to rise to the levels seen in the recent past.
This may explain, it is argued, why US 10-year yields have fallen to around 4 per cent in recent months, from 4.6 per cent a year ago, even as short-term rates have risen from 1 per cent to 3 per cent over that period.
Paradoxically, this unwavering confidence in the central banks causes a problem for the Fed, however; the fall in longer-term rates offsets to some degree the effect of rising short rates and hence dilutes the impact of any monetary tightening.
The US housing market, for instance, is strongly influenced by long-term bond yields, and so fixed mortgage rates have also fallen sharply of late.
Consequently, the US housing market has yet to slow down, and the average price of an existing home in the US rose by 15 per cent in the year to April, a 30-year record, with some areas seeing much larger gains.
The implication is that short rates may have to rise further than they previously would in order to counteract the expansionary effect of lower long-term rates.
Higher short rates may therefore eventually push bond yields higher if the market reassesses the likely peak in the Fed cycle, but there is a second factor at work, boosting the demand for government debt.
This relates to company pension funds and the large shortfalls recorded by many in recent years. New accounting rules mean that the current market value of the pension funds' assets and liabilities have to be disclosed, revealing huge swings in net liabilities, given the short-term volatility of equity markets.
As a result, there is a strong body of opinion arguing that such swings in liabilities can be dampened by reducing the weight of equities in pension funds and raising the weight of bonds.
This can set up a vicious cycle though, if enough funds are convinced on the case for bonds. A shift out of equities can itself reduce stock values and hence the value of assets still left in the fund.
In addition, the future liabilities of the pension fund have to be converted to a present value, which is done by using a longer dated bond yield as the discount rate.
A shift by funds into bonds, by depressing bond yields, also raises the present value of future liabilities, which further compounds the pension deficit.
The irony, from an Irish perspective, is that bond yields are historically low at a time when the State is a net investor, via the National Pension Reserve, and not a borrower.
Dr Dan McLaughlin is chief economist at Bank of Ireland
