The next big play: gilts grab the spotlight

The Thing with bandwagons is, if you miss one, there's usually another just around the corner. Investors who missed the boat on betting which countries would qualify for Europe's single currency in 1999, or those who think there is little profit left in the strategy, are turning to the bonds of countries expected to join a few years later.

That is likely to push down borrowing costs for Britain, Sweden and Denmark - nations not expected to be among the first wave to join European economic and monetary union, though likely to apply for membership once EMU is underway.

"There's better value in these markets than in, for example, Italy and Spain," said Stewart Cowley, the head of global fixed-income for Hill Samuel Asset Management's $13bn.

Buying 10-year Italian or Spanish bonds offers less than a 60 basis-point premium than investing in German bonds, Europe's benchmark market. British bonds deliver better than 100 basis points, while Denmark and Sweden, both with better economic track records than Spain and Italy, offer 50 and 60 basis points.

Monetary union looks increasingly like a done deal, with the political drive to forge a single economic bloc outweighing the difficulties some nations have faced clearing hurdles designed to ensure synchronisation between the EMU members' economies.

Deutsche Bank research unit, for example, now reckons there is an 80 per cent chance of a "broad" European monetary union starting in 1999. In April, it put the likelihood at 67 per cent, and at just 55 per cent earlier this year.

Deutsche predicts Germany, France, Italy, Belgium, Luxembourg, the Netherlands, Austria, Ireland, Finland, Spain and Portugal will be the first wave of countries to adopt the euro. Their bond yields have compressed, with the gaps investors used to exploit for profit shrinking erased by improved economic discipline of governments battling to qualify for EMU and the prospect of currency risk on their bonds disappearing.

Moreover, those gaps have shrunk faster than many analysts and investors expected. The gap between Italian and German yields, for example, took six months to get to 200 basis points from 400, less than four months to halve to 100, and sprinted to 60 from 100 in under a month.

The speed caught many by surprise, with yield spreads not expected to dissolve until next summer. Strategists recommend getting in early on the next big play, with gilts likely to be the main beneficiary of new investor interest.

"The bet is that bonds of the countries that should be there in two years' time get there earlier," said Alison Cottrell, the chief international economist at PaineWebber International. "For an investor, the gilt market is sitting there waving at you."

British bonds got a boost last week when it was reported that the Government is considering joining EMU soon after the 1999 start date, which would mean a referendum on dropping the pound earlier than expected.

Some bond buyers think the UK is in a "heads you win, tails you don't lose situation" once the single currency gets started. One effect of early British entry into EMU would be to push the pound lower. The Government is not likely to strap itself back into the European exchange rate mechanism at current levels, which are crippling British exporters. The pound is now worth about 2.83 marks, up from 2.62 marks at the beginning of the year.

Rob Hayward, an economic adviser at Bank of America, said unless investors become sceptical about the Government's commitment to EMU, "the pound will move down gradually to the level at which people believe it would join the ERM, and that's the 2.60-marks area".

Of the four Nordic countries, only Finland is due to join EMU at its launch. Sweden is preparing to join some time later because of lack of public support for membership. Denmark decided in a referendum in 1993 against joining, and has secured an opt-out clause allowing it to resist signing up even if it meets the economic qualifications. "If it's a true story, then it's a question of revaluing the market," said Thomas Kristiansson, a fund manager at S-E-Banken Fonder in Stockholm. "I can't see any reason why Sweden wouldn't follow Britain."

Other analysts agree. "The fate of Sweden and Denmark that will be made totally by Tony Blair and nobody else," said Carlo Eraekallio, chief strategist at Svenska Handelsbanken in Stockholm.

"He will take Sweden into EMU, as well as Denmark a bit later on. I believe the UK will change its attitude fairly soon."

There's a powerful cash incentive for Britons, not renowned euro-enthusiasts, to vote in favour of joining the common currency. As this column pointed out last week, countries joining the single currency will also end up with a shared official interest rate.

With British base rates at 7 per cent, compared with German rates of 3 per cent, a British vote to join EMU could be a vote for lower mortgage rates. Whether that will be enough to swing the promised referendum remains to be seen.

Additional reporting by Jeff Brooks and Sandy Hendry.

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