EMU `backed by bond yields'

Bond dealers expect European monetary union to go ahead on time, according to the Bank of England's Governor, Eddie George. Speaking at the Euromoney International Bond Congress in London yesterday, he said: "The fact that yield curves in Germany and France are practically identical is consistent at least with EMU going ahead - at least with a narrow membership."

But at the same conference, leading commercial economists diverged from the bond market view, expressing serious doubts that EMU would go ahead on time.

The pattern of future bond yields reflects traders' expectations about inflation in the years to come. Yield curves for French and German bonds have converged to be almost identical, showing that the markets expect inflation in the two countries to be identical in future too.

Mr George pointed out that five-year forward yields in Italy and Spain remain significantly higher than in Germany and France, "suggesting that early EMU membership [for Italy and Spain] is not at all certain in the eyes of the market". However, considerable convergence has already taken place; the interest rate differential between German and Italian 10-year bonds has fallen by around 4 percentage points in the last two years.

Germany and France also show a steep rise five years down the line. Mr George claimed this "suggests that inflation is expected to be higher in the medium term. That could be associated with expectations of softer macro-economic discipline."

In particular, the Governor said, this could reflect market uncertainty about the strength of the new single currency, and about "how far the European Central Bank will in practice be free to pursue its statutory task of maintaining price stability".

Roger Bootle, chief economist at HSBC, was among the speakers doubtful about EMU going ahead on schedule. "The odds are against it happening on time," he said.

Simon Briscoe of Nikko Europe rated the chances of a single currency on schedule as 50-50. George Magnus of UBS said the chances were 60 per cent, "but the percentage is falling".