Flash Gordon, hero of the bond universe

The new Labour government is proving to be a smash hit with investors both at home and abroad, who have rewarded its decision to give the Bank of England control over base interest rates by cutting the country's annual bill on its debt interest payments by pounds 750m.

Moreover, the decline in UK bond yields since Labour won power on 1 May - a good indicator of how much faith the global investment community has in the country's economic prospects - looks set to continue, as the Government shows investors it is even more committed to low inflation than the Conservative Party was.

"Moving policy power from government bureaucrats to professional bankers shows there is deep respect among the Labour politicians for the central bank," says Ravi Shankar, fund manager at Zurich Investment Management. "I really like the way they're acting."

Gilts had their best day for almost three years last week after the Chancellor of the Exchequer, Gordon Brown, put the Bank of England in charge of British interest rate policy.

Even though Brown also raised base rates by a quarter-point to 6.25 per cent, which would typically spark a bond market sell-off, benchmark 10- year gilts soared. Investors drove the value of British gilts up by more than pounds 2 per pounds 100 bond, knocking 30 basis points off the yield.

Based on the Bank of England's calculation that each 1-basis-point drop in yield trims pounds 25m per year off the interest rate bill on the national debt, that's an annual saving of pounds 750m.

To check what investors think of Britain's chances of matching Germany's recent record of keeping inflation under control, it is instructive to compare how much investors are charging to lend to the two countries by buying their bonds.

The annualised gap between 10-year UK and German yields - a measure of the additional risk investors perceive in gilts - has dropped to 140 basis points from more than 180 basis points before the election. The narrower the gap, the more investors believe Brown won't blow it by letting inflation get out of control. Investors have more faith in Labour's Flash Gordon, it seems, than they had in cuddly Kenneth Clarke.

Joanne Collins, the Nomura Research Institute UK economist who tipped gilts at the beginning of the year as the best bond market to buy in 1997, says she expects the yield spread between gilts and German bonds to narrow to 125 basis points in the coming months, with a 100-basis-point spread achievable further down the road.

"The new government will take a very proactive stance in establishing credibility with the financial markets," says Ms Collins. "Labour wishes to be seen as more economically responsible than the previous government."

Investors applauded the move to let the central bank set rates, which Mr Brown said was designed to free monetary policy from political pressure. In future the central bank will take the flak for raising interest rates.

"The hard work is now ahead of the central bank," says Sven Rump, a fund manager at Vontobel Investment Management. "It takes a long time to build credibility, and it is easy to lose it."

Mr Rump, who increased the gilt investments in his portfolios even before the election, says the bank's independence will make a big difference in increasing the attractiveness of gilts to overseas investors. He also sees the gilt yield premium to German bunds narrowing to 100 basis points by the end of the year, cutting Britain's interest rate bill by a further pounds 1bn.

Labour's shift on the control of monetary policy brings Britain into line with other countries such as Germany, France and the US. Investors typically are willing to lend more cheaply to countries where politicians do not hold the interest rate reins, because they tend to have a better record of fighting inflation.

Since the Reserve Bank of New Zealand was granted independence under a 1989 act of parliament, for example, the country's underlying rate of inflation has halved. Central bank Governor Donald Brash's employment contract obliges him to keep the annual underlying inflation rate between zero and 3 per cent. Miss the target, and he can be dismissed by the government.

His job looks safe. New Zealand inflation was down to an annual rate of 1.97 per cent in March, from 2.4 per cent at the end of 1996. Moreover, the central bank is predicting inflation will fall to 1.5 per cent in the second half of this year, then to 1 per cent early next year. In three years' time, inflation is expected to be about 2 per cent.

Foreign investors have rewarded the New Zealand central bank's inflation achievements by driving bond yields down to about 7.7 per cent from more than 12 per cent at the beginning of the decade.

Gilt yields are not likely to halve from their current level. Still, the prospect of further rate rises from the Bank of England in the coming months, as it tries to push the inflation rate down to the government's target of 2.5 per cent or less, means that gilts should prove more profitable than other European bond markets.

"Central bank credibility is built up in a hard manner. You have got to play tough to begin with," says Mr Shankar at Zurich Investments. "I don't see any danger of a resurgence of inflation."

Moreover, while Mr Brown said earlier this week that it remained highly unlikely that the UK would join a single European currency on the 1 January 1999 start date, investors perceive the Labour government as more likely to join in European monetary union project than a Conservative administration would have been.

Although Labour has promised to hold a referendum before Britain would consider joining a single currency, Ms Collins of Nomura believes that "the odds that Labour will guide the UK towards EMU have risen sharply, even if it doesn't happen in the first wave."

If the UK begins to look more likely to join monetary union, its bond yields would fall to match those in Germany, which sets the pace for European bond yields.

As Sven Rump of Vontobel put it, Labour's election victory could well mean "welcome to the euro" for UK citizens. Last week Flash Gordon helped prepare the way. Copyright: IOS & Bloomberg