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Take your seats - bond and sharemarket vigilantes get set for a showdown

The Reserve Bank conceded yesterday that the direction of the next move in interest rates was outside its control. It acknowledged a wall of worries - Europe's sovereign debt crisis, America's economic slowdown, the consumer spending strike, "subdued" lending growth, soft house prices, the high Australian dollar, lacklustre jobs growth and the final fading of the government's crisis spending. Taken together they had all helped lower the near-term growth outlook.

The Reserve Bank conceded yesterday that the direction of the next move in interest rates was outside its control. It acknowledged a wall of worries - Europe's sovereign debt crisis, America's economic slowdown, the consumer spending strike, "subdued" lending growth, soft house prices, the high Australian dollar, lacklustre jobs growth and the final fading of the government's crisis spending. Taken together they had all helped lower the near-term growth outlook.

It repeated its growth and inflation meme: the resources boom is still going, growth appears set to accelerate in the medium term, and the risk of inflation breaking out above its 2-3 per cent target range remains.

But comments about a growth rebound and the inflation threat it contained were both modified by the same caveat: growth will return to trend or higher "unless the world outlook continues to deteriorate".

And the inflation outlook depends on "the extent to which softer global and domestic growth will work, in due course, to contain inflation".

The big answers will come from over there, in other words. If the world shrugs off its troubles and surges forward, rates are headed higher here, because the commodity price boom and the price pressures it is creating will intensify. If the global economy succumbs, we could get interest rate cuts, and get them quite quickly.

That in turn will depend on the result of an ideological battle that has been one-sided , but may not be from now on.

Bond market vigilantes are in the ascendant right now. They have hunted in packs before, to push bond prices down and yields up as inflation rose around the world in the '70s for example, to the point where policymakers cracked down on growth in the '80s to contain inflation, and set up a 30 year bull-market for bonds that also pulled shares higher.

This time the bond market vigilantes want Europe's cot case economies to cut spending, raise taxes and get their debt under control. They also want similar austerity elsewhere, including the UK and the US (even as, paradoxically, they rush to the safety of US and UK gilts). And this time, sharemarkets want the opposite.

Citigroup equity strategist Robert Buckland says there are nuances - bond investors with exposure to the EU problem nations also favour intervention and bailouts, while those exposed to the stronger north including Germany oppose them.

But the basic demand is primal: give me my bond coupon and don't compromise your ability to do so by issuing too much debt and let my real rate of return be undermined by inflation.

Europe's bond vigilantes are in command as usual this week, attacking Italian bonds as Italy tries to push through a ?45.5 billion ($60.8 billion) budget austerity package and roll more than ?60 billion ($80 billion) of debt.

They have also pushed the yield on Greek debt past 50 per cent for the first time as Greece fights yet another of its quarterly battles to qualify for more financial adrenalin. Europe's banks are caught in the vortex, their share prices spiralling down.

While bond market vigilantes helped sharemarkets in the '80s and '90s by forcing a low inflationary regime that also resulted in price-earnings multiples expanding, the new vigilante attack is bad news for stocks because if it succeeds it will bear down on economic growth, corporate profits and dividends.

The emergence of sharemarket vigilantism to counter bond market vigilantism and lobby for policies that stimulate economic growth is both desirable and overdue, Buckland believes. If pressure for policies that chase economic growth raises "inflationary risks and threatens the credit rating of the northern European nations, then so be it - that's the bond market's problem," he said.

But sharemarket vigilantes are going to struggle to grasp the tactics of extortion. It is high-risk game that in this case would involve pushing the prices of the assets progressively lower in the face of signs the bond market vigilantes were going to get what they wanted. The idea is to get policymakers to blink, but there could be unintended consequences.

A relief package that involved a recapitalisation of Europe's banks would, for example, dilute existing shareholders. Goldman Sachs recently told its clients that up to $US1 trillion ($945 billion) of new capital may have to be found.

The near to medium fate of this economy and the commodity markets it feeds off hangs on whether policymakers listen to the bond markets or the sharemarkets. If the bond vigilantes continue to have the squirrel grip, the next interest rate move here is down.


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