Gilts suffering from double-whammy effect

The Investment Column

The first few months of this year have not been kind to the gilts market and there is not much chance that matters will improve with the arrival of spring. The redemption yield on the 15-year benchmark stock has climbed more than half a point since January and is now stuck above 8 per cent. Gilts have been hit by a double-whammy - political risk and inflation fears.

Gilts are caught between the different state of the economic cycle to the east and west of the UK. The prospect of the Bundesbank cutting short- term interest rates in the next few weeks means other European markets have decoupled from the nervous US Treasury market since the early part of the year. One worry troubling investors is the risk that the UK economy is more likely to pick up, like the US, rather than stay in the doldrums with Germany and France.

Extremely favourable US figures for inflation at the factory gate last month reassured Treasury bond investors yesterday that the Fed would stay its hand. But there are other clear signals that the American economy is recovering strongly from its pause, with an ever-tighter labour market and upward pressure on wages. Further pointers to economic strength are likely to send bond yields up again. They are already at their highest for a year.

The evidence on the UK economy is more mixed, but signals such as rapid monetary growth, a strengthening consumer sector and rising asset prices have been interpreted in some quarters as early inflation warnings. Even if that is a bit alarmist, growing evidence that the economy is starting to grow a bit faster mean the odds of further base rate cuts have receded. Traders in the futures market are currently betting on there being no fall from the current level of 6 per cent, with base rates rising again by the autumn.

On top of this, the run-up to the general election does not look like being a happy period for the gilts market, for a mixture of reasons. One risk is a pre-election surge in public sector borrowing. Gilts issuance is already higher than expected a year ago because government tax revenues have been disappointingly low. On past form it is sensible to expect the Government to ease up on control of the public finances even more as election day approaches.

However, an additional concern is how much more a Labour government might want to borrow. The party's plans have so far not been spelt out in detail, although the shadow chancellor Gordon Brown has pledged to be tough on the public finances and retain some sort of inflation target. A new report from investment bank Goldman Sachs estimates that political risk should not add more than half a point to gilt yields before the election.

However, it cautions that the market has not yet taken this into account. So with both politics and economics conspiring against gilts, investors are in for a further bumpy ride.