Gilts face slow progress towards recovery

How long can the bond markets' ill-temper continue before fixed-interest securities again appear good value? Viewed rationally, there was little new bad news in the two UK indicators published yesterday but the gilts market still reacted badly, pulling equities down with it.

The trigger for the markdown was a sell-off on the European bond markets, but that seems more of an excuse than a reason. If markets want to move in one direction they can usually find an excuse.

For once the picture of the economy at this moment is remarkably clear. All the recent data - retail sales, unemployment, plus yesterday's figures on GDP and non-EU trade - points to the fact that the economy is now enjoying a solid, steady recovery.

At the moment the recovery is largely consumer-led. Retail sales volume has been running between 3 and 4 per cent up year on year since the early part of last year. The rise in taxation ought to pare this back a little, but it won't stop it continuing to climb. In fact it needs to pare back consumption growth, for the next stage of the recovery ought to be sustained by investment.

The growth phase of any recovery will be supported at different stages by different components of demand, and for all sorts of reasons investment needs to take over the baton. Exports will continue to improve - there is nothing wrong with the performance - but the present rate of import growth cannot be sustained without a worrying balance of payments deficit becoming alarming. In any case, investment needs to rise simply to meet additional demand.

Looking ahead, the picture is less clear, for we do not know whether this shift in the components of demand will take place. If it does, everything comes right and the expansion can be sustained. If it does not we are back to stop-go, because sooner or later the old familar balance of payments crisis will choke off the expansion. City economists are evenly divided about the danger of just such a crisis, a division reflected in the gilts market.

The pessimistic view, which was dominant yesterday, is that the risk- reward ratio for gilts is unattractive. Given the solid nature of the recovery it is clear that we are close to the bottom of the interest rate cycle. We are not going to see in Britain the very low interest rates which occurred in the US.

There will also be some cyclical rise in inflation as the recovery progresses and the long-term trend is now sideways, not down. While gilts yielding close to 8 per cent might seem to offer good value in relation to inflation, the risks of something going wrong in the coming months are such that they may well offer better value.

The optimistic view is that the risks are smaller than the market thinks, and the long-term structural position of the gilts market is stronger. On inflation, while there might be some upward cyclical movement, the long-term trend is still down. Paradoxically, the very weakness of bond markets around the world is testimony to the fact that the long-term trend of inflation will continue to fall, for the markets are now exerting their own discipline. If, at the modest threat of renewed inflation, they swiftly push up long- term interest rates, that inflation cannot be sustained.

Further, as far as the UK is concerned, the structural position this year is vastly better than last. Only about half as many gilts need to be sold. The gilt funding arithmetic has been done by NatWest Markets, the investment banking side of the clearing bank. It calculates that total net gilt sales in the financial year just finished was pounds 49.5bn. This year it calculates that net sales will only need to be pounds 22.2bn.

This improvement is the result of a number of factors. The PSBR last year was probably a little less dreadful than forecast - pounds 45.9bn against a budget forecast of pounds 49.8bn. This not only could lead to some overfunding which can be carried forward to this year, it also suggests that the forecast for this year may be too pessimistic - NatWest estimates that it will be pounds 36bn rather than the projected pounds 38bn.

NatWest believes that these pounds 22.2bn of gilt sales should be reasonably easy to clear even without foreign participation. True, the stock will have to be sold against a very different interest rate environment from last year - the prospect of rising short-term rates rather than falling.

But against that is the 'value' argument. Investors who believe that the long-term trend of inflation is still down will have the opportunity to lock into a fixed yield which may not be available in the future.

All these arguments about the risk-reward ratio in the gilts market have to be set alongside events in other world bond markets. Any general sell-off, as took place yesterday across Europe, will have an impact on the UK, for gilts are just one financial product for the international investor among many.

But continental Europe is two years behind the UK in the economic cycle, so surely it is illogical to see an early turnabout in continental interest rates. Further falls there will help to sustain bonds.

Realistically, given the present mood it would be odd were the tone of the gilts market to improve radically for some months. But unless something dreadful happens to inflation (of which there is no sign) or to the balance of payments (which is possible) the tone of the market ought to improve - partly because it offers good value, partly because fewer gilts will be on sale. By the autumn this should be clearer to all.