An inverted curve is good for the Old Lady

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The Independent Online
Back in April, this column warned that UK base interest rates were likely to rise by a full point in the months following the general election, judging by what was going on in the interest rate futures market. Base rates then were 6 per cent.

Two rate rises this summer - one by Gordon Brown as soon as he took office in May, the second by Eddie George in June after he was given the monetary policy reins - have put base rates at 6.5 per cent.

With Brown perceived to have soft-pedalled on the consumer tax increases needed to puncture public spending and keep inflation down in his Budget last week, the interest rate futures market is anticipating further rises in base rates - maybe by as much as half a point to 7 per cent, and perhaps as early as next week.

What's more, there might be yet more rate rises later in the year.

While higher interest rates are typically bad news for the bond market, investors are giving Eddie George and the Bank of England's new monetary policy committee a huge vote of confidence in their ability to keep inflation smothered - even if it has to crank up interest rates to do it.

For the first time in five years, the yields on UK bonds with maturities of 10 years and more have dipped below those with shorter maturities. The UK is the only major bond market in the world where the yield curve is inverted, a phrase traders and investors use to describe a situation where bond buyers charge the government more for short-term borrowing than for longer-dated loans.

Three-year gilts currently yield about 7.18 per cent, 10 basis points more than 10-year gilts. It's the first time three-year yields have been higher than 10-year yields since 17 September 1992.

This illustrates that the market expects tough monetary policy to keep a lid on inflation.

"The shape of the yield curve is because people think the monetary policy committee will do enough to keep inflation under control," said Tony Turner, bond manager at Norwich Union Investment Management.

For gilt investors, the best returns in the months ahead are likely to come from bonds maturing in 10 years and more, analysts said. High rates will hammer short-dated securities, while the prospect of inflation staying in check will underpin the long end.

"My expectation is the short end of the curve suffers more than the long end," said Andrew Milligan, senior economic advisor at GA Investment Management.

Bonds with longer maturities are more sensitive to expectations for inflation, while those with shorter maturities move with shifting expectations for the central bank's rate changes.

One investor who's betting on improved returns in longer-dated gilts is George Inderst, head of the fixed income team at Foreign and Colonial Investment Management.

Inderst said his team invested in 10-year and longer-dated gilts at the beginning of 1997 in anticipation that returns on those securities would outstrip shorter-dated gilts.

Expectations for more rate increases surged last week after Brown unveiled the Labour Government's first Budget. The Chancellor didn't raise taxes enough to slow consumer spending and prevent the central bank from raising rates, investors said.

Which leaves the job of stopping inflation climbing to the Bank of England.

"We're certainly in for a boom period when higher interest rates will need to be used," said Keith Kelsall, fixed-income manager at Fiduciary Trust International Ltd.

Yields on shorter-maturity gilts soared as Brown announced details of the Budget, pushing three-year yields higher than 10-year yields for the first time in five years.

In September 1992, however, the last time that happened, base rates were 10 per cent, well above their current 6.5 per cent. The annual inflation rate was 4.2 per cent, compared with 2.5 per cent today.

Gross domestic product, meantime, had slumped by 0.1 per cent in the third quarter of 1992, and had fallen for seven successive quarters.

This time around, the yield curve is inverting even as the economy has expanded for 18 successive quarters, with growth the best it's been for more than two years.

One of the main things driving the economy is a surge in consumer spending, as former building society members spend the windfalls they're getting from the rush to convert to publicly-traded banks.

Higher estimates of how much money those windfalls might pump into the high street, which are likely to allow retailers to start raising prices and rekindle inflation, have helped bolster expectations for how high the bank is likely to drive interest rates.

One unusual feature of current UK gilt yields is that there's a bigger difference between two- and three-year yields than between three- and 10-year yields.

Two-year gilt yields are at 7 per cent, three-year yields are at 7.14 per cent and 10-year yields are at 7.03 per cent.

"The curve is in a period of huge change, so we shouldn't be surprised if we see short-term pricing anomalies creeping in," said Inderst of Foreign and Colonial Investment Management.

Three-year gilt yields may rise to as much as 30 basis points above the 10-year yield in the next three months, he said, with further inversion signalling growing expectations that the central bank is succeeding in its battle against faster inflation, analysts said.

"It's unprecedented to have an inverted yield curve when base rates are so low," said Huw Roberts, European bond strategist at NatWest Markets. "It's a huge vote of confidence for the Bank of England." Copyright: IOS & Bloomberg

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