Outlook: Bond market bulls bank on Federal view of deflation threat

Supermarket bids; Cordiant puzzle
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The Independent Online

Sir Edward George, the Governor of the Bank of England, says the chances of deflation both here and in the US are extremely small, and he thinks it "pretty low risk" in the eurozone too. His views won't be welcomed by those that remain bullish about bond markets, which is still a large number despite what is already one of the longest bull runs ever.

Bond yields as they presently stand are seem only barely justifiable even on the consensus view going forward of subdued inflation and low interest rates. Already they are at a level which leaves little margin for error. Even assuming central bankers succeed in holding inflation to around the 2 per cent mark as measured by the harmonised index of consumer prices, the real rate of return is pathetically small. The running yield on 10-year Treasury bonds in the US is down to just 3.34 per cent. In the eurozone, the equivalent yield is 3.71 per cent, while even in the UK the running yield is only 4.12 per cent.

The continued bull case for bonds rests on the idea that although central banks might find it easy to stop inflation moving above 2 per cent, they will find it much harder to prevent it slipping significantly lower. Whether the world succumbs to outright deflation may be beside the point; very low inflation and growth over a period of years would be quite bad enough. What makes the deflation debate so intriguing from an investment perspective is that for the first time in three years, equity yields are again moving in parallel with bond yields. Since equity markets bottomed out on 12 March, both asset classes have been getting more expensive. There are bulls for equities and bonds in equal measure. Unfortunately, they cannot both be right. If the bond surge continues, as many respectable voices such as those at HSBC anticipate, then it can only be because inflation and growth continue to fall, which cannot be good for the revival in corporate earnings equity market bulls need to justify their stance.

Another way of saying the same thing is that if we really are back into bull market territory for equities, then the bond market is a bubble waiting to burst. The precedent is the early 1990s when bond yields halved, only to be chased back up again when the Federal Reserve tightened policy to choke off inflation.

Crucial to the way the bonds versus equities match plays out is quite how seriously the US authorities take the threat of deflation. The evidence so far is that they already take it very seriously indeed. Unlike British and European policy makers, who lightly dismiss deflation as highly unlikely and focus instead on the old enemies of asset bubbles and inflation, Alan Greenspan, chairman of the Federal Reserve, has openly discussed the issue. Possible non-conventional counter measures, such as buying in bonds to reduce the cost of capital, have been publicly aired too.

The more difficult question is whether the Fed really believes it a significant risk, or is just using it as an excuse for pro-growth policy. We may get a clearer idea after tomorrow's meeting of the Federal Reserve's Open Markets Committee.

A quarter point cut in US rates may not tell us very much, other than that growth remains subdued, but a full half-point cut, taking short-term rates to below 1 per cent, combined with a continued weakening bias would more than vindicate the bond market bulls, at least in the short term. Any accompanying statement to the effect that the Fed is considering the use of non conventional measures would further bolster their case.

So the HSBC view that the yield on the 10-year US Treasury bond will fall to as low as 2.5 per cent by the first half of next year may be correct. If US inflation falls to just 1 per cent, as HSBC suggests it might, such a yield looks very plausible. On the other hand, the Fed has a habit of overly aggressive reaction when it thinks growth is threatened. It tends to be equally aggressive in reversing those policies when the threat disappears, as occurred in 1993/4, causing many bond market bulls to lose their shirts.

The bond market bull may be allowed to rampage about the place for a while longer yet, but at some ill-defined point down the road there's a great big bull trap lurking in the undergrowth.

Supermarket bids

Perhaps surprisingly, the Competition Commission has come up with some rather sensible observations in the remedies letter it sent out yesterday to the various parties in the bidding war for Safeway. Unfortunately we are no nearer knowing the outcome for it, and nor, I imagine, is the Competition Commission.

On the one hand, the commission seems to accept that any adverse public interest consequences in all four competing supermarket bids for Safeway can be dealt with through store disposals, rather than outright prohibition. It has also dismissed the suggestion from the Office of Fair Trading that the drive times used for calculating the overlap between competing stores be increased from the previous benchmark of 10 minutes in urban areas and 15 minutes in the country to 20 minutes. Any such notion would have hugely increased the degree of overlap, and the consequent store disposal programme faced by all the rival bidders.

On the other hand, the commission insists that the competition authorities remain in control of any disposal programme. Disposal to a buyer that would make competition poorer in the locality, or to someone that would take the store out of commission for groceries altogether, would be unacceptable, the commission suggests. This might make it practically impossible for the three biggest supermarket groups to devise credible bids, as they couldn't know whether the terms of any required disposals would be acceptable to the authorities.

Furthermore, the commission concedes that a Morrison/Safeway merger might actually be pro-competitive in creating a powerful fourth national player to provide competition to Asda, Sainsbury and Tesco. If the commission really believes this, then it must logically prohibit the others. It would also need to think about mechanisms for banning Philip Green, even though he hasn't been referred. Hey ho.

Cordiant puzzle

The first rule of holes is that when in one, stop digging. Active Value Fund Managers doesn't seem to have learned it to judge by its continued acquisition of shares in Cordiant, the advertising group which is being taken over by Sir Martin Sorrell's WPP. Yesterday Active Value bought another dollop at a price half a pence above the value of Sir Martin's 2.4p-a-share offer, taking its total holding to 24.53 per cent. Active Value has long argued that if Cordiant is refinanced and a new management team is installed, then it has a perfectly viable future as an independent company. Whether or not this view is correct, it's hard to see how it can succeed.

Cordiant is already in default of the conditions of its £255m of debt. The present waiver runs until 15 July, at which point Cordiant can be put into administration. What's more, WPP has already bought out most of that debt from its previous holders, so in all respects it now holds the whip hand. If Active Value blocks its takeover, it will just put Cordiant into administration and then buy the business from the administrator, leaving shareholders with nothing at all.

It's always possible that Active Value has a cunning plan nobody else has thought of which enables Cordiant to avoid an administration, but if so, we ought to be told. If Active Value really has got alternative refinancing proposals up its sleeve, and the backers to make them work, why doesn't it air them? The board would be obliged to accept anything that offered shareholders a realistic prospect of better value than the WPP terms. The more likely explanation is that having been outmanoeuvred, Active Value is squandering its money in a pointless display of bravado.

jeremy.warner@independent.co.uk

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