Riddle of the red screens: As the gilts market has suffered arguably its steepest fall since the First World War, shares have been sucked down as well. Rupert Bruce explains why this occurred in a rising economy

WHEN market-makers, the wholesalers of shares, arrived at their desks at 7.30am last Monday their first calls were to the bond markets. Their worst fears were realised. Both German and British government bonds were sharply lower.

The market-makers followed suit and punched lower share prices into their keyboards. By the time fund managers and other big stock market investors switched on their screens at 8.30am, they were greeted by a sea of red - the colour that indicates falling prices and, if you happen to be an investor, pain.

The FT-SE 100 - the index of 100 biggest British quoted companies known colloquially as the Footsie - opened 33 points down. Further falls in the bond markets then triggered a knee-jerk fall in the all-important Footsie index futures contract - the popular device that enables investors to take a bet on the Footsie's future level.

Despondent market-makers responded by marking share prices down again and again. By lunch, the Footsie was 73 points down at 2,949 - one of its biggest one-day falls. It recovered somewhat in the afternoon, but was still off 52 points when the market shut at 4.30pm.

It was to prove the start of a lousy week for the stock market. It fell heavily again on Friday, when central bankers failed in their efforts to support the dollar. Investors feared that UK companies selling goods in the United States might see their dollar profits fall. The Footsie ended 66 points lower at 2,876, a new low for the year.

Overall the stock market fell 146 points over the week, wiping about pounds 33bn from the market value of British companies.

In previous bear markets when share prices have slumped, market-makers - who buy and sell shares in the same way as pawnbrokers buy and sell trinkets - have talked of panic selling and dealing rooms have smelt of fear. But last week the atmosphere was perfectly calm: just gloomy.

Derek Riches, a market maker and director at Smith New Court, the broker, said Monday was typical of conditions that have hung over the stock market since February, when share prices started their staggered fall. 'There is a depressed atmosphere when bonds seem to have steadied but open weaker. There has not been a major drive of selling. It is just a reflection of the weakness in the gilt market and the German bund (government bond) market.'

Just as when sterling was about to fall out of the European exchange-rate mechanism (ERM), all eyes were on the pound's value against the mark, for the last six months share traders have anxiously watched bond prices. And in the last few days a new factor, the dollar- yen rate, has also attracted some of their attention.

Michael Hughes, global strategist at BZW, the investment banking arm of Barclays, said: 'The fall in bond prices, or rise in bond yields, is arguably the biggest since the outbreak of World War One in terms of the rate of change in such a short period of time.'

Gilts have fallen with German government bonds. The yield on high coupon 15-year gilts has risen from 6.6 per cent on 29 December to 8.93 per cent on Friday. At the same time the price has fallen by more than 18 per cent. The fall in the FT-SE 100 has mirrored this and it is down 18 per cent since its zenith on 2 February.

The daily pattern of price falls has repeated itself again and again. Falls start in the bond markets and then move to the financial futures markets.

When the Footsie futures contract starts to fall, market- makers slavishly follow suit and mark down individual share prices.

The fall in the stock market has been stealthy. Instead of falling day after day, there has been an irregular drip of big one-day falls followed by a few days of stability or partial recovery, followed by further falls.

And if there has been no selling of equities, there has been no buying either. David Manning, a director at the big life insurance company Legal & General, said with irony: 'We are aggressively sitting on our hands taking a look at what will happen to bond markets.' This is what is known in the markets as a 'buyer's strike'.

Where there has been some trading is in the bond markets. Some of the banks and big trading funds that bought bonds heavily in 1993 in anticipation of falling interest rates have become forced sellers this year. As worldwide bond prices started to fall in anticipation of the rises in the US Fed Funds rate that started on 4 February, investors who had borrowed heavily to buy bonds for what they thought was a one-way bet in 1993 had to sell.

Investors who had, for example, put up security of pounds 1 to borrow another pounds 9 and invest pounds 10 in bonds, only had to suffer a 10 per cent fall in bond prices for their security to be wiped out. Small price falls had a knock-on effect as injured investors were forced to sell more and more to meet losses, causing further price falls.

According to several market pundits, this unwinding of leveraged positions is still going on.

But why should the stock market start to fall just when the British economy is recovering and company earnings - which are supposed to drive share prices - are rising?

Mark Tinker, UK strategist at stockbroker James Capel, said: 'We are seeing a handover of the baton, from the stock market being driven by weight of money to being driven by economic growth. But this consolidation phase has been very, very messy.'

David Roche, global strategist at Independent Strategy, the investment consultancy, takes a similar view: 'UK share prices are falling for the same reason that a lot of equity markets in the world are. Equities are perverse: they go up when economies are down. When economies are down, governments and central banks generate a lot of liquidity.'

In this country, the Government reduced base rates to make it cheaper to borrow money and stimulate the economy. At the same time, interest rates were very low in the US. A wall of 'hot money' - funds moved opportunistically around the world for the highest short-term gain - hit stock and bond markets all over the world, and the UK was no exception.

Other analysts have more fundamental fears. They talk about high inflation returning as the UK economy revives. Britain has typically been a high-inflation country, and the Chancellor, Kenneth Clarke, has yet to convince financial markets that he will put low inflation before political gain.

Mr Tinker believes these inflation fears are misplaced. 'Greed drove these guys in the bond markets last year. They thought they were geniuses. And now the bond market has turned round there is fear; they think there are all sorts of ghosts out there,' he said.

Nils Taube, the veteran stock market investor and principal investment adviser at St James's Place Capital, said: 'The whole point is that everyone is banging on about inflation, but I think it is simply the fact that the opening up of a vast part of the world to foreign capital means that there is a lot more demand for investment capital.' That is exactly the situation that drives up interest rates.

There are a hundred varieties of bulls and bears with varying degrees of optimism and pessimism about where the stock market goes from here.

Mr Tinker predicts that when bond markets settle down, investors will see the value in the stock market - and it will rise sharply.

At BZW, Mr Hughes is more moderate. He said: 'I think we are entering the stage of the game where an increasing part of the total return from shares comes in the form of income. I would expect a return after inflation of 5 per cent in each of the next two years.'

Mr Manning, at L&G, is also reasonably optimistic. But he allows himself some doubt. He is concerned about the effect of the fall in bond prices and rise in bond yields, which makes it more expensive for companies to borrow money over the long term.

'There is a real danger that higher interest rates could start to stifle the economic recovery that we have seen around the world,' he said.

While the balance of opinion suggests that shares will rise from here, there is a chance that bearish prophecies could be self-fulfilling. As bears sell bonds and the dollar, they make it more expensive for companies to borrow and reduce the profits of companies selling goods in the US. And that is bound to dampen economic activity.

(Photograph omitted)