After a long period of sustained growth, bond and equity markets in the United States have become increasinly volatile in recent months. Investment manager Mr. E. T. (Bob) Richards looked at the background to recent falls in the markets in a recent investment outlook.

Bond and equity markets have fallen very dramatically recently, particularly during the final week of the first quarter. The whole thing seemed to be sparked by the increase by 25 basis points twice in the space of six weeks in the Fed Funds rate (the interest rates charged by the Federal Reserve to US member bands). It was a so called "pre-emptive strike'' against future inflation. This move ended an extended period of accommodative Fed policy, but it needs to be taken in perspective.

During the 1980s, the Savings & Loans were not the only financial institutions in difficulties, the banking industry was in serious jeopardy, with asset quality and capital ratios at dangerously low levels. Instead of bailing them out, as was the case with the S&L's, the Fed aggressively lowered their cost of business, (the Fed Funds rate). Bank profitability and asset quality was eventually restored and the system was saved in a painless way.

The raising of the Fed Funds rate has signaled that the banking and economic rescue posture of the Fed is over and that a more "normal'' neutral and watchful stance will now be adopted.

There appears to be virtually no anecdotal or statistical evidence of inflation in the US economy. The only evidence is that the US economy appears to be growing rather robustly.

As we said in our last writing, the nature of this expansion is led by big gains in productivity, rather than increases in consumption. Such an emphasis is non-inflationary. Moreover, the US is much more dependent on the international economy than in previous economic cycles, so we need to look overseas at their inflationary situations and capacity utilisation. The EC, except for the UK and Switzerland, are still in recession and therefore have high amounts of slack in their economies. Inflation there is being savagely squeezed out of the system by the Bundesbank with high (but declining) real interest rates. In Japan business is still slow with inflation muted and a seemingly infinite amount of productive capacity available to be brought on line in China.

There is no corroborating evidence in the gold markets either. Gold is very sensitive to inflationary expectations, but this leap in bond yields has not been accompanied by a corresponding rise in the gold price.

The reverse of what the Fed's expectations of their actions has happened.

Their actions have spooked the bond market instead of giving it confidence that inflation would be kept in check. We said at the beginning of the year that we anticipated an upward move in interest rates, this has transpired. We anticipate that bond markets will retrace their steps in the coming weeks and months; a 7.44 percent yielding long bond is not justified by the evidence at hand relative to inflation.

The stock market has been and is still a captive of bond yields and short term interest rates. Investments in the issues recommended at the first of the year did very well until this latest market downdraft. However, the emphasis on productivity enhancement, technology, multimedia still is in place.

The US picture has not been duplicated in non-US markets. We had warned of the vulnerability of the Hong Kong market. Shortly after our last writing Hong Kong started a major correction, which is still underway.

Tokyo had been in meltdown for the past two years and started its recovery at the beginning of this year. It has not been seriously affected by the volatility in Wall Street. Gains have been particularly strong in US dollar terms due to the strength of the Yen. These developments underscore the prudence of diversifying portfolios across geographical boundaries.

Mr. E.T. (Bob) Richards is an independent fund manager and president of Bermuda Asset Management.