`There are only two conclusions any sensible investor can draw. Either gilts are too cheap, or Italian and Spanish yields are too low'

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The Independent Online
One of the enduring fascinations of financial markets is that they periodically take leave of their senses and, for seemingly plausible reasons, completely misprice the securities which are traded on them. It is at such moments that the smartest investors step in to profit from this collective myopia. Those who can see the woods for the trees start behaving, in the words of the US investor Warren Buffett, like "an over- sexed man in a harem".

Are we seeing such a moment of market madness in the European bond markets? For months now, the price of these bonds has been driven by the markets' perceptions of what was going to happen with Economic and Monetary Union. A year ago, the consensus view in the markets was that EMU was dead in the water. Few investors believed there was a realistic chance of even the core European countries of Germany and France being ready to meet the scheduled starting date of January 1999.

As long as that view prevailed, the markets continued to price government bonds on the basis of traditional bond market investment criteria - the outlook for inflation, the strength of the currency, and the state of the economic cycle, among others. As these vary significantly across Europe, the spread between the yield on bonds issued by the best regarded economy (Germany) and that on bonds from the relative basket cases (high-inflation countries such as Italy and Spain) was a wide one. As befits a country that has built its post-war economy on the back of an unshakeable belief in preserving the value of the Deutschemark, Germany has always been able to borrow money more cheaply than anyone else in Europe.

A year on and the whole picture has turned on its head. The consensus has swung round to the belief that monetary union will go ahead on time after all. Britain will not be at the starting gate, but the so-called Club Med countries (Italy and Spain) will - so the markets have convinced themselves - have a good chance of joining the Germans, French and Benelux countries.

The result of this volte-face has been a dramatic convergence in shift in relative yields on bonds issued by the likely entrant countries. Although German bonds still offer the lowest yields, the margin with everyone else's has narrowed sharply. The yield on 10-year German bonds is now around 5.85 per cent, with French bonds of the same maturity at an almost identical level. You can now buy Italian government bonds on a yield of 7.6 per cent and Spanish bonds on a yield of 7.25 per cent.

The differential between German and Club Med countries has fallen, in other words, to well below 2 per cent. Yet less than a year ago it was more than twice as large - 4 per cent to 5 per cent. Two years ago Italian bonds were priced well into double figures - 6 per cent more than German bonds. That was the price investors paid for the fact that Italian public finances are among the worst anywhere in Europe.

The whole point of monetary union is to tie the fortunes of all the main European countries to a single currency, forcing the weaker members to swallow the same monetary medicine as the Germans. Once monetary union occurs, devaluation will no longer be an option for the Italians or the Spaniards, and in those circumstances it makes sense for the differential with German bond yields to narrow towards vanishing point.

But the speed and pace at which the markets have moved this year is a surprise. Monetary union is still over two years away. The Bundesbank, the German central bank, is fighting a rearguard action to make sure that the tough entry criteria laid down at Maastricht on budget deficits, inflation and the level of public debt are not fudged by the weaker countries. The markets' assumption that the project will go ahead with Spain and Italy aboard is not the foregone conclusion that their bond prices imply.

When you look further afield, the anomalies are even more striking. As nobody now assumes that Britain will join the single currency, the price of our government bonds (gilts) has not been affected by the convergence elsewhere. In fact, gilt yields are now virtually the highest in Europe. For the first time in years, a UK Chancellor is paying a higher rate of interest on government debt (around 7.5 per cent) than the Spanish or Italian finance ministers.

This is absurd, given respective inflation records. True, the British economy operates on a different economic cycle from the rest of Europe. It has been growing steadily for three years while most of Europe is still in the downturn phase. You would expect interest rates to be relatively lower on the other side of the Channel at this stage in the cycle. It is true also that Britain's long-term economic performance is not much to shout about: sterling has depreciated steadily against the mark for 25 years.

But even so, there are only two conclusions any sensible investor can draw. Either gilts are too cheap by comparison with their European counterparts, or Italian and Spanish yields are too low. Despite recent signs of a pick- up in inflation, my view is that gilts are not unattractive at current levels, and I expect them to become more attractive still as the election approaches. At these prices, a real return of 4 to 5 per cent is not a bad reward for the risks involved. More likely still is that the markets' sudden burst of enthusiasm for the EMU convergence story will prove unsustainable - and that the differential in bond prices will adjust accordingly. If that happens, then some smart people are going to make a lot more money from the process unwinding itself.

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