Where the power lies

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The Independent Online
London follows New York, not Frankfurt. That would seem to be the message from the City's markets yesterday, for the cuts in German interest rates were largely ignored while the fears of rising US rates continued to drag markets down.

What did help the markets - including bond markets on the Continent - as the afternoon wore on was not the announcements by the various European central banks that they too were cutting their rates, but the fact that New York recovered some poise.

It is an interesting lesson of where power lies in the world of finance. The Bundesbank is important because it sets not just German short-term interest rates but the interest rates of a great swathe of northern Continental Europe - the greater Deutschmark zone.

Yesterday's decision is wholly consistent with its policy in previous economic cycles, when it has eased its monetary stance steadily and incrementally. Sometimes the Bundesbank moves just a little later than the markets might have expected, sometimes a little earlier, but yesterday's muted response suggests that this time there was little real surprise.

But, while the Continental bond markets initially jumped in response to the move, they quickly moved back down again. Any would-be sellers of German bonds took the jump as an opportunity to offload stock.

You can understand London looking across the Atlantic, for the US and the UK economic cycles are reasonably close. The British cycle lags the US by perhaps a year, but not more. But it is much more difficult to make an intellectual case for German bonds following the US market.

The German economic cycle is about two years behind the British and three behind the US. Policy will continue to tighten in the US for another two years, maybe longer, but will loosen in Germany for another 18 months.

There, in a nutshell, is one of the great investment issues of the moment. Will financial markets decouple in the same way that economies have decoupled? Or will the financial cycles remain more or less synchronised? The message of yesterday was the latter, which requires an explanation. The most plausible runs like this.

Bond markets respond not just to movements in the economy or in short-term interest rates but to long-term perceptions of reward and risk. There are quite independent reasons why investors might be cautious about bond prices in the US, Germany and the UK.

In the US, the long expansion of the economy is mature, the five- year decline in short-term interest rates is over and there are signs of a rise in inflation. In Germany none of those negative factors exist, but there are others. One is concern about the size of the budget deficit, another the slow progress in correcting that deficit and a third the overvalued level of the mark.

In Britain there is also concern about the budget deficit but more confidence in the progress in correcting it and only limited concern about sterling. Investment, however, carries the risk that a politically motivated Chancellor will force the Bank into unwise rate cuts. (Whether that fear is justified is another matter. The difference of opinion between the Chancellor and the Governor of the Bank revealed yesterday over the latest base rate cut suggests that the Chancellor's problem may just be inexperience. He is still having to do the job on a very low knowledge base, but he will learn.)

If there are different reasons to be cautious about these three bond markets there are also some reasons to suspect that the violent shake-out that occurred in the past three months is now over - but different reasons in each case.

In the case of the US, there is reasonable long-term value in a way there was not two months ago. In Germany bond yields will be supported by further easing of monetary policy. And in Britain you have to be very gloomy about inflation and interest rates over the next 10 years not to see good value in gilts yielding 8 per cent.

STRUGGLE IN US

But if all bond markets seem to be offering value the potential upside is different in each case. In the months ahead US markets will have to struggle against a gradual tightening of monetary policy. That will limit the extent to which bond yields can fall.

In Germany, on the other hand, the prospect of two more years of falling rates ought to underpin that market as well as creating the possibility of substantial profits should inflation fall more sharply than seems to be happening at the moment. And here in Britain the potential upside is also large if inflation remains very low.

For a few months more these bond markets may well remain coupled, with the lead coming from New York. But because the upside potential is larger on this side of the Atlantic the chances are that markets here will do better.

Politics, not economics, could upset this picture. The US political scene is a known quantity in that the threats to the President are fully identified. The German (and maybe the British) political outlook is less clear. Were the Social Democrats to win in Germany this autumn, financial markets would react badly. So we might find US and German markets again moving in the same direction, but for different reasons.

And here? At a guess the removal of John Major as Prime Minister in the autumn is already 'in the market', but the possibility of the Conservative government not running its full term under a new leader is not yet in the City's mind at all.

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