View from City Road: Markets driven by fear

It was a good week for bond markets, gilts included. In a year when bond values worldwide are thought to have declined by something in the order of dollars 1,500bn ( pounds 968bn), that is, perhaps, not saying much. None the less, it is beginning to look just possible that markets are on the turn. Benign inflation figures, here and in the US, have helped to calm investors' nerves.

The outlook for bonds is critically determined by market expectation of future inflation. It is starting to look as if this might be foolishly high. If it is, then bonds are better value now than they have been for years.

Though inflation in the industrial countries is at or near its trough, few forecasters expect a dramatic upturn. Yet to the chagrin of monetary authorities, the implication of present bond yields is that investors expect the worst.

In a recent bulletin, the Bank of England went through the exercise of calculating the forward inflation rates implied by present yields on conventional and index-linked gilts of different maturities. The broad thrust is that inflation will be above 4 per cent by 1998 and 7 per cent by 2000 before declining subsequently.

These expectations are higher than the Bank thinks justified even though it recognises that for monetary policy, as with everything else, it takes years to rebuild a shattered reputation. They are also higher than most forecasters are predicting.

Some investors are coming round to the same view: inflation expectations are unduly pessimistic and bonds are as a consequence very good value. There is a health warning, however. It will be hard to feel confident about an improving trend until there is more liquidity in world bond markets. Japanese investors are still, for instance, highly worried about currency risk. As a consequence they are still unwilling to commit wholeheartedly to bond markets. Until they and others regain their confidence, markets are likely to carry on being driven by fear rather than by fundamentals.