The gilt-edged query MONEY
NICHOLAS DAVENPORT
The only part of the Stock Exchange which is happily looking forward to a terrible budget is the gilt-edged market. As one firm of brokers tersely put it, if a complete freeze on incomes is imposed the gilt-edged market will probably be satisfied with an extra £200 million of taxa- tion, but, if not, the dividing line between a bullish and a bearish reaction to the budget will be more likely to be in the region of £400 to £500 million extra taxation.
Do not imagine that the institutional inves- tors who comprise the gilt-edged market are a bunch of puritanical killjoys. If they thought that Mr Wilson would resign this autumn they would be uncorking bottles to celebrate the prospect of a return to lower surtax and income tax. But they are conventionally puritanical about the balance of payments. They believe that an improvement in the trade figures de- pends on a tough budget and they will not feel bullish until they see it or until they know that the trade unions will accept the wage freeze which is coming, and in the meantime the trade figures are getting worse.
All this, of course, is playing politics and the gilt-edged market is not really very good at it. For example, it got into a panic last month when the Vote on Account seemed to point to a rise of about 7 per cent in real terms in government spending this coming year. Sterling, it con- cluded, was in peril again. When the Treasury explained—as it should have done beforehand— that it was only a part of public spending and that overall the rise, as forecast, was under 4 per cent in real terms, the'market recovered quickly. But it should not have listened in the first place to Mr Heath. It should pay more attention to M Pierre-Paul Schweitzer, the managing direc- tor of the IMF, who now says he is confident that sterling 'will pull through' and that the budget will be tough enough to reap the full benefits of devaluation. If he is satisfied—as well as those hard-faced gentlemen from Paris, who have lately been visiting our country for all the world like spies from our creditors—there is no need for the market any longer to play politics.
And politics is not really what the gilt-edged market is about. It is more properly concerned with the supply of money and the rate of in- terest. Curiously enough, if it were solely that, it would be bounding upwards before the budget. For a Bank rate of 8 per cent has be- come so ridiculous that Mr Jenkins can hardly fail to reduce it to 7 per cent on 19 March. Why Mr Callaghan raised it by 14 per cent on devaluation day I cannot imagine. Presumably someone told him to do so for its psychological effect, but its psychology has been appalling. An 8 per cent rate has been proclaiming to the world that British socialist politicians do not know how to manage our monetary affairs. It is not attracting foreign money to London in sup- port of sterling and it is costing the Treasury an extra £30 million or more in interest charges on the sterling balances held from overseas. Why pay this costly premium for overseas funds which would be held in London in any case?
Since devaluation the Bank of England has not been supporting the forward exchange rate in sterling. This has been the correct policy; there is no permanent gain in feathering the nest for international 'hot' money. The result has been that the market automatically adjusts the cost of the forward exchange cover to even out the arbitrage profit. (At the moment there is an arbitrage profit in New York's favour.) There is, of course, an arbitrage profit if 'hot' money is left in London uncovered for a very short period, but the margin is so high—upwards of 4 per cent—that Bank rate could be cut to 7 per cent without upsetting the inflow of these unim- portant funds. I cannot believe that a British Bank rate of 8 per cent has now any significance in the international monetary world except as a joke.
Actually interest rates abroad have been moving downwards since the beginning of the year. When President Johnson announced his plan to cut the American overseas deficit by $3,000 million it was expected that there would be a rush on the part of American subsidiaries in Europe to borrow on the Euro-bond mar- kets and so drive up the rates. Certainly there was a rush, but the continental bankers were determined to keep interest rates down, and they have kept money easy. The result has been an unexpected fall of 10s. or # per cent, in the Euro-dollar three-month borrowing rate in the past two months. Dr Emminger, of the Bundes- bank, recently said that there is now little justi- fication for expecting a rise in the Euro-bond or Euro-dollar rates.
As regards interest rates in the us the three- month bill rate has been remarkably steady at around 5 per cent in spite of the President's failure to secure the tax surcharge. It is true that Mr McChesney Martin, the chairman of the Federal Reserve, has warned that it might be necessary to keep money tight even if taxes were increased and government expenditures reduced, but that does not necessarily put up the cost of industrial borrowing. The reason why interest rates have not risen this year in America is the quite dramatic change in com- pany finances. In 1967 companies borrowed heavily in the long-term capital market and so boosted their liquidity. This year higher sales and profits have improved their cash flow, and though their potential capital programmes re- main high, their money situation remains easy. Indeed, it could become easier as remittances from their overseas subsidiaries flow in from the President's new measures. Moreover, if the mounting Vietnam war begins to interfere with their domestic spending programmes and their capital projects are held up or postponed, bor- rowing rates might even fall. A similar situation threatens in Europe. The cutting of American spending abroad could make European trade recede.
The idea that the present gold rush, which puts the dollar under strain and indirectly sterl- ing, must be met with dearer money is pure non- sense. Neither of the reserve currencies can be saved by dear money. The fact that gold boarders and speculators are already paying high interest charges in order to buy gold on which no interest is paid proves that money rates do not enter into the bargain. The serious view is growing that the present monetary sys- tem cannot survive its present strains and stresses without a rise in the price of gold and, as I have explained two weeks ago, 1 believe that view is correct. It is certainly the lesser in a choice of evils. And as soon as monetary re- serves are doubled by doubling the price of gold interest rates will be tumbling down.
But to come back to our gilt-edged market. Its technical position has been strengthened first by the sharp falling-off in the debenture and loan issues of companies—precisely the same as in the us--and secondly by the widening of the 'reverse yield gap.' Long-dated government stocks are now yielding 74 per cent and short- dated even 74 per cent or more, while equity shares return only 4.7 per cent on dividends and 5.7 per cent on earnings. Who would want to sell gilt-edged to buy equities on these terms, even if the trade figures look temporarily bad?
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