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Investment view

Last week saw one long-standing leader toppled and replaced by what many view as an upstart. No political infighting this but rather the emergence of the corporate bond market as the dominant force in the fixed-interest arena in this country. UK Government bonds have been overtaken in value by corporate and other non-Government bonds for the first time since the Second World War. What is more the gap – pres-ently minuscule – is expected to widen.

In part, this is due to the British Government issuing less in the way of gilt-edged securities. Balancing the books has been the name of the game at the Exchequer recently. Overall UK Government borrowing is on the decrease. Even the appetite for gilts is on the wane, helped by the steady fall in yields over the past decade or so. At the beginning of the 1990s, double-digit yields were achievable. Even five years ago, a gilt-edged stock with a life of 15 years would have returned above 8 per cent. Today, yields are little more than 5 per cent. If pension funding rules are changed, even these forced buyers of Government debt may look elsewhere.

Contrast that with the yields on corporate bonds. There are FTSE 100 companies offering more than 250 basis points over the comparable gilt. According to the Barclays capital equity/gilt study, corporate bonds returned a real 10.5 per cent a year over the decade to the end of 2000, beating gilts which delivered 9.4 per cent and surprisingly close to equities, where the 10-year average was 11.8 per cent. True, interest rates fell over this period but at least this result was achieved without quite the volatility of the equity market.

Interest rates have been kind to the bond market, as has inflation. The future direction of interest rates in this country suddenly seems in doubt, thanks, it seems in no small measure to the historic second landslide victory of Tony Blair&#39s Government. Just four years ago, the Chancellor surprised us by handing over interest rate policy to a Bank of England. With the other hand he took back several billion pounds of taxes by ending of some of the privileges enjoyed by our pension fund industry. No wonder a surprise or two is expected this time around. What greater (or lesser, in reality) surprise could there be than a Europhile Prime Minister bouncing us into monetary union. An early move in this direction is what markets are telling us will happen.

Personally, I don&#39t see it taking place at quite the speed some commentators are forecasting. For these reasons, we need to return to interest rates and their Siamese twin, inflation. The monetary policy committee of the Bank of England has been heavily focused on the plight of manufacturing industry, where recently published statistics confirmed a recessionary environment remains. They will also be aware that lurking behind them is the spectre of the American consumer staying at home. With little inflationary pressure here, the MPC has found it easy to lower interest rates. This could change if sterling continues to weaken.

Unfortunately for the Government, the prospect of a lower pound and thus higher import prices is not the only blot on the inflationary landscape. Higher petrol and food prices are exerting upward pressure. And as if dearer potatoes and lettuce are not enough, average earnings have breached the Bank of England&#39s upper target, suggesting wage inflation could return to haunt us. Forget convergence. Interest rates cannot continue to fall if there is any danger that the cost of living will break out on the upside of the Chancellor&#39s expectation. This is not a climate in which plunging into the euro pool will be contemplated. And to think we all expected Sir Edward to have to write that letter apologising for allowing inflation to fall below 1.5 per cent.

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