Coaxing the gilt bulls

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The excellent producer price figures were just the tonic for the mature bulls of the gilt market. The bullish tone of the market is not in dispute - last week saw another stong price performance enabling the Bank of England to clear a lot of stock. That the bull phase is mature is equally self-evident. The year to end September was about the best 12-month period for the gilt market since the Second World War.

But mature bull markets need coaxing: new entrants need to be assured that though earlier buyers have enjoyed a wonderful run, there is still some potential left. There needs to be a series of pleasant surprises. It is worth listing these potential bull points, for quite a lot hangs on a secure gilt market: there are some years of fiscal deficit ahead.

First there is the inflation outlook. There were two points of importance in yesterday's producer price index. One was that it gave further confirmation that everyone was wrong a year ago when they predicted that devaluation of sterling would inevitably feed through in higher inflation. It always had before, but this time the quite different business climate has led to a quite different effect. Devaluation did force up some input prices, but firms have in general sought to offset these by pushing for further gains in efficiency.

The other point is that if a 2.5 per cent rise in the pound against the dollar was able to have such a beneficial impact on input prices, there is potential for further good numbers if the pound can nudge up further. A pound at dollars 1.65 is perfectly plausible.

But it is always wrong to make much of one month's figures. Anyone buying gilts is making a bet on inflation over 10 or 20 years, not two or three. More helpful was the suggestion last week by the Bank's new deputy governor that the inflation target should be 1 to 2.5 per cent rather than 1 to 4 per cent. The practical point here is that the gilt market, with long yields in the 7 per cent region, is discounting the wider target, but not fully discounting the narrow one. If inflation were to stay under 2.5 per cent, gilt yields of 5 per cent would be realistic.

Can one official, albeit a fairly senior one, put a figure into the public arena and have an impact on policy? If it is to do so, it will be through the markets: they will demand a better performance on inflation, rewarding the Government if it succeeds and punishing it if it fails. That would attribute a lot of power to the markets, but it is not completely unrealistic.

The world climate helps here. It is not just that countries with a reasonable tradition of price stability are still trying to push inflation down; the other laggards are doing better, too. Italian inflation is down in the 4-5 per cent region despite an even sharper devaluation than sterling. The process of disinflation in Britain is part of an international trend.

Next, the public sector's finances. The Bank has already done about three-quarters of its funding needs for this financial year, putting it in a very strong psychological position vis-a-vis the market. It is no longer worried about selling enough stock. In any case the PSBR projections are falling. Even with minimal tax increases in November we should get a PSBR estimate for the 1994/5 fiscal year of about pounds 37bn, with a projection of about pounds 25bn- pounds 29bn for 1995/6. As long as the direction is down, the markets will stop worrying. For Britain's public debt at 53 per cent of GDP is still quite low. That is an OECD projection for 1994. Comparable figures for Germany are 64 per cent, France 61 per cent, Italy 116 per cent.

Naturally a case could be assembled that the market is simply too mature to warrant a much longer run; that in the next six months there will inevitably be worse news on inflation; and that the whole world bond cycle will turn round. Maybe. But that is not the news the market is interested in at the moment, and this suggests that this market has still a little way to run.

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