Putting the US bond rally into perspective

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The Independent Online
It is perhaps unusual in these days of instant information to try to put an historical perspective on financial markets, but here goes anyway. It is little more than a year since the Federal Reserve punctured the great bond market bubble by raising US interest rates. In the past week, bond yields have virtually returned to where they were when the Fed took that fateful action.

Bonds in fact began to fall sharply well before the Fed's tightening. The key US policy rate was held at 3 per cent from July 1992 to February 1994 but long-term bond yields began rising sharply from the autumn of 1993. They were already past 6.5 per cent when the Federal Funds rate went up. The peak, the bottom of the bear market, was well past 8 per cent.

Since late last year the crash in the US bond market has been unwinding. In the past week or so the rally has become dramatic. We are still nowhere near the giddy heights of the bubble, but even so the recovery during the past 15 months, as the graph shows, has been pretty good going. Will it continue?

The bond rally boils down to a market vote of confidence in Federal Reserve chairman Alan Greenspan. Mr Greenspan was one of the first people in America to point out - in testimony to Congress in March - that the pace of the economic recovery was slowing and inflation was well under control. He said then that the peak in short-term interest rates was near. Since then, almost all the economic data has borne him out. The markets have concluded interest rates might go up by at most another half a point later this year and could come down early next year. It has been party time on Wall Street. A fall in industrial output? Buy bonds! Two other developments have helped. One is that the dollar seems to have stabilised, bringing foreign investors cautiously back into the market.

The other is the apparent progress on cutting the gargantuan US federal budget deficit. Mr Clinton wants to cut it. The House of Representatives wants to cut it. So does the Senate. Even if the balanced buget plans before Congress are watered down in the usual way, there is more hope than at any time since Ronald Reagan moved into the White House of achieving significant reductions in planned government spending. The bond market has rewarded politicians' good intentions with a few more ticks off long bond yields.

Of course, if Congress starts the process by passing tax cuts before spending cuts, the reward will be withdrawn. The bond market would also wobble if their was a renewed onslaught on the dollar. But the serious threat to the rally would be an earlier than expected rate increase from the Fed. If Mr Greenspan spotted unacceptable signs of inflation or still- excessive growth before market participants, he could jolt long bond yields back above the psychological barrier of 7 per cent again. Even so, the bond market crash is history. Long term, it may even be seen as barely more than a hiccup.

Interesting sums from Warburg

Dear old Warburg appears to be going out with a final flourish of largesse. Cost savings were never its forte, but the pounds 100m of fees, expenses and contingencies said to have been charged against the acquisition by Swiss Bank Corporation of its investment banking business appear generous even by City standards. An air of mystery surrounds these costs, since there was no confirmation of the figure in the circular sent to shareholders yesterday. On the other hand, it has not yet been denied. The figure is not all it seems in any case, for it includes a big provision for the costs of disentangling Mercury Asset Management from the Warburg group as well as something for redeeming preference shares.

Even so, such costs, which amount to 5 per cent of the near pounds 2bn value the transaction puts on SG Warburg Group, look excessive in the extreme. Advisers usually get around 1 per cent. Furthermore, in most transactions the biggest costs are incurred on underwriting, which is not a part of this particular exercise. The only item so far quantified in the grand total is the pounds 35m being paid to MAM for the trouble of extracting itself from the Warburg group, losing the right to trade under the Warburg name and having to move premises overseas. For that sort of inconvenience, MAM appears to have been very handsomely compensated. But let's for the moment give Warburg the benefit of the doubt and accept that this is a reasonable pay-off.

There remains pounds 65m to account for. Schroders and Cazenove, the two main City advisers, might have charged pounds 5m between them maximum. Legal and other fees could have amounted to pounds 10m or so. That still leaves an awful lot of beads on the abacus before reaching the grand total. The only possible explanation is that the difference is accounted for by tax and other provisioning.

All this does not affect the 365p a share in cash shareholders have already been promised; the payout was calculated after charges. None the less, this is still pounds 100m, worth about 40p a share, which shareholders would otherwise have been entitled to. That inevitably raises the question of whether this is quite as good a deal as had been thought for Warburg shareholders. It seems that Warburg is having to shoulder some at least of the restructuring costs associated with being taken over. Normally the bidder would pay. Taking into account these costs, it is possible that Swiss Bank is actually paying a small discount on net assets rather than the premium that has been widely supposed. Warburg's need must have been greater than it cared to admit to.

Mercury makes a low-cost call

Mercury's decision to introduce a single national call rate for residential customers is a smart marketing ploy but will hardly have BT quaking in its boots. Those taking advantage of the initiative will have to pay a higher basic charge, so the cost to Mercury is probably negligible. Furthermore, the residential market that would benefit from the new tariff structure - ie, those that make a lot of trunk calls - is comparatively small. It remains to be seen how BT responds, but it might choose to do nothing.