Bonds calm amid the storm

The European Commission said yesterday that government deficits are too high, while our new Chancellor declared that he will cut the British one as quickly as is practicable. But if governments are borrowing in a profligate way, the world's financial markets do not seem to mind.

They have certainly failed so far to punish the borrowers, indeed rather the reverse. Long bond yields have been coming down in almost every industrial country this year.

Since, in the past, the main power that has forced changes in policy has come from financial markets, perhaps the rise in public sector indebtedness has some way to run.

Well, perhaps. There are several possible explanations for the calm way in which the bond markets around the world - for this is very much an international phenomenon - have responded to the rise in budget deficits and it might be helpful to list some of them here.

Part of the answer lies in the fall in both actual inflation and in expectations about future inflation. The markets cannot quite convince themselves that inflation is really beaten, but virtually everyone in the world of finance would accept that the long-term secular trend of inflation is downwards and has been since the late 1970s.

So the only issue is whether there will be a sharp upward blip in the next cycle or a minimal one. Most bond-watchers have been impressed by the failure of US inflation to rise despite the easy money of the Fed. Here, too, there is remarkably little sign of a return of inflation psychology. Perhaps what has happened to the housing market is responsible.

In its most extreme form, the 'low inflation is here to stay' thesis would maintain that even if governments wanted to create more inflation they would find it quite hard to do so, such is the change in the way people think about money, jobs and interest rates. And of course, providing inflation does stay low, the real return on fixed interest securities remains high, so that this school can argue that government securities still offer good value despite the fall in yields. At least, wealthy governments are not going to default on their debt - all they can do to cheat the holders is to try to inflate or devalue their currencies.

But this is by no means a complete answer. Another part of the explanation for the strong bond markets is the lack of an alternative. Deposits are unattractive and the two biggest equity markets - the US, and, in a rather different way, Japan - are quite fully valued.

On the risk-reward ratio, bonds look attractive. Besides, anyone who bought into bonds during the past year will have made a lot of money. French yields in particular have come tumbling down, from more than 9 per cent last September at the height of the ERM crisis to below 7 per cent now. (Given the pressure on the franc, this might be the time to cash the chips.)

If, however, deficits were going to continue to pile up for the forseeable future, at some stage the markets would revolt. The fact that they are showing no such concern suggests that an implicit assumption is being made by buyers that action will be taken to curb these deficits. Looking round the world at the way in which just about every major country bar Japan is tightening fiscal policy, that seems reasonable.

Or rather it would be, were it not for three things. One is that the move into deficit has been so marked that taxes have to go up quite a long way, or spending come down, before deficits will be back under reasonable control. A second is that the demographic pressures on governments will increase over the next decade, cutting their revenue and increasing pressure on their spending. And a third is that international competition in taxation is cutting away at their revenue base.

These are all slow burners - problems for the early years of next century as much as for the last years of this. The fiscal position of a country is not transformed overnight. And such is the way markets think that they will need some trigger - probably an unrelated one - before they start to worry.

But at some stage over the next 12 months the interest rate cycle will start to turn. Expect US short-term rates to nudge up early next year, perhaps sooner. That will unsettle financial markets, which will see a rolling movement of rates turning up across the rest of the world.

Eventually, perhaps in two years' time, the cycle will hit Germany. If, by next spring, credible debt reduction packages are not in place in all G7 countries bar Japan, long-term rates could come under pressure.

For the moment, then, all is well. Governments are trusted by the markets and are supplying a fine stock of reasonably high-yielding securities into which savers' money can be stashed. True, some are more trusted than others, but in most cases it is an ideal situation. There is plenty of stock from very loose fiscal policies but the prospect is of a tighter supply and a better financial underpinning of the stock that has been issued as deficits are cut.

The danger is that the ability of markets to absorb this enormous amount of securities will end quite suddenly. The bucket will suddenly overflow. There have been buyers' strikes before.

As far as Britain is concerned, this is not an immediate danger. Sterling is back in fashion and has some way further to rise against the ERM currencies. There is a modest yield advantage over ecu stock. And, since gilts have always been a very liquid market, people can get out if things turn nasty. But Mr Clarke's advisers are probably more worried than they admit in public, and that is why they have persuaded him to talk tough.