View from City Road: Gilt markets decline to be comforted

Another day, another dollop of good news, another bond market collapse. Yesterday's bearish activity on the European bond markets was provoked by the German government's decision to pull a DM10bn issue of bunds.

The cancellation should have sounded a positive note for the market makers, since it will reduce the supply of bunds. Instead it merely served to remind investors of a similar issue pulled last week because of poor market conditions. These days even good news is reinterpreted as bad.

Underlying all this negativity is the way the markets have convinced themselves that the fall in German interest rates is all but over and that rates may start edging up later this year.

And not only on the Continent. Back at home, gilts also suffered from similar worries, as the latest figures showed a surge in money supply just as the market was in the process of lifting its expectations for UK growth this year. Domestic buyers stayed on the sidelines and foreigners, worried about sterling, have deserted the market.

Forecasts of higher rates at home are easier to understand than expectations of higher German rates, however. After all, the UK recovery is entrenched and it looks increasingly likely that inflation has passed the low point. Germany, in contrast, is enjoying a faster-than-expected recovery, with the best news on inflation still to come.

The bearish sentiment on German rates can be traced to a recent hint by Hans Tietmeyer, the Bundesbank president, that cuts in key interest rates have come to a end, and to a surge in the growth of German broad money supply, M3, far above the 6 per cent upper end of the Bundesbank's target range.

Enough people take seriously the Bundesbank's commitment to bringing it back within the stated zone - eventually - to worry that the best news on rates is over.

As a result, even if today the Bundesbank drops the repo, its leading market rate, from its current level of 5.2 per cent, it may have little impact. So it was easy to see why German bunds led European markets down almost a point at the day's worst levels and why gilts sank 1.5 points before staging a lacklustre and partial recovery.

But there is a strong case for arguing that market fears about German rates are overdone. This is, after all, an export-led recovery, and domestic consumption remains weak.

If the recovery is to be maintained, the mark must remain competitive, implying that a bit more on rates is still to come. Meanwhile, German bund yields are around 7 per cent and offer good value after deducting inflation of 2.9 per cent, to give a real yield of 4 per cent.

Remember, too, that further inflation falls are still to come.

The picture is quite different in Britain where the expansion looks perky and inflation is set to deteriorate late this year. There may be good fundamental reasons for buying European bonds. It is a lot harder to be enthusiastic about gilts.