Despite the euphoric market reaction to Labour's landslide victory in last year's general election -- and the immediate granting of operational independence to the Bank of England -- UK Gilts are still yielding over 100bp more than German Bunds.
Given the strong position of the UK government finances and the powerful economic fundamentals in the country, analysts and traders believe this spread is far too high.
And international investors have been quick to take advantage, pouring money into a Gilt market whose structure has been substantially improved by nearly four years of rolling reform.
Forward spreads imply much greater convergence, suggesting confidence that the UK will eventually be part of Emu and that the UK's economic strength merits a much closer spread to Germany.
But there is also a risk that UK institutional money may start to desert the UK government debt market in favour of the more liquid investment alternatives in the new euro-land. In that case, say sceptics, the lack of new supply may render the Gilt market as little more than an illiquid, irrelevant backwater.
In the week following the UK's general election of May 1 last year -- which saw Labour sweep to power with a huge majority -- Prime Minister Tony Blair and his new cabinet virtually redefined the expression "honeymoon period".
A decade or so ago, the idea of a Labour Party controlling the UK's purse strings almost certainly by adopting the old tax-and-spend policies would have plunged the City into the depths of despair. This time around, it greeted New Labour with open arms.
By May 7, the Labour Party, once a demon in the eyes of the City, had London-based economists virtually purring with a combination of delight and relief.
As Morgan Stanley noted towards the end of the first week of May, "pre- and post- election worries about a Labour Party victory in the UK's general election on Thursday, May 1 evaporated in about half a day's trading the following day. By May 6, both bond and equity markets were giving a unanimous 'thumbs up' to the resounding Labour victory."
"Our contention," continued the euphoric bulletin, "that this Labour Party is the most market-friendly Labour Party the UK has ever seen has been backed up by Gordon Brown's immediate move to increase the independence of the Bank of England -- an early and reasssuring move to show that inflation is a priority for this government."
This, combined with more constructive remarks about Emu, "have cut 35bp off the UK bond yield spread over Germany," noted Morgan Stanley.
Others were equally delighted, but also stunned, by the speed with which Chancellor Brown acted and by the powerful Gilts rally which followed. As Salomon Smith Barney concisely noted on Friday, May 9: "Tuesday's rally was so fast that many investors missed it."
It was not just the Bank of England's independence which was greeted with euphoria by the markets. Unashamedly taking a leaf out of a book written on the other side of the planet -- in New Zealand -- Chancellor Brown also announced, in the words of a press release from the UK's Treasury, that "the Bank of England's role as the government's agent for debt management, the sale of Gilts, oversight of the Gilts market and cash management would be transferred to the Treasury."
There is, however, a limit as to how far the enthusiastic back-slapping for what Labour has achieved for the Gilt market can go, for two obvious reasons.
In the first place, as one London-based banker points out, Bank of England independence was in some respects the icing on the cake for the Gilts market following four years of rolling reform initiated under the old political administration.
Second, if what has been achieved in the Gilts market since the general election is measured in the most brutal and analytical way -- in other words in terms of basis points -- precious little has been won. Following the euphoric aftermath of the post-election announcement and the tumbling of the Gilt-Bund spread which accompanied it, the differential between the UK and Germany has remained surprisingly high in the eyes of many analysts.
As one says, "with the spread at 100bp plus, there's clearly scope for massive tightening. If you ask what is the correct spread for Gilts over Bunds you could argue that it would be zero or even negative."
"It is probably a matter of some concern and disappointment to the government that its debt servicing costs on a spot basis are still more than 100bp more than Germany's," says David Boal, vice president in the Gilts department at JP Morgan in London.
"People are asking themselves: how can this be when the UK has probably got the lowest debt to GDP ratio of any major European economy, together with a very low deficit which is probably heading for a surplus next year?
"And how can this be when we have seen Gilt market reforms leading to regularised auctions, the introduction of repos and strips, the removal of anachronisms such as the special ex-dividend and the move towards making the market decimal? In spite of all this -- twinned with the strong state of the government's finances -- we still have not seen a big compression in yield spreads versus core Europe."
In some respects, the government and the new Debt Management Office (DMO) need not lose too much sleep over the stubbornly yawning gap between Bunds and Gilts, for a number of reasons.
First, forward spreads make decidedly better reading, with the five year forward spreads at 25bp over Germany and 10 year forward Gilts trading through the Bunds.
"So looking ahead the market is already pricing in the good UK economic fundamentals and to some degree rewarding the UK market for better transparency and efficiency in the Gilts market," says Boal.
In reflection of these forward spreads, nobody seems to imagine that the Gilt-Bund spread will stay in three digit territory for long. In its fourth quarter review of the sterling bond market, for instance, SBC Warburg Dillon Read predicted a six month fall in the spread to Bunds to 73bp, and a 12 month fall to 49bp.
Salomon Brothers also foresees a fall in the UK-German spread, commenting in its first quarter outlook that "the Gilt-Bund spread is likely to plunge to about 0.6% by the end of 1998."
In a number of other respects, however, bankers do believe that the government should at least be alive to some of the concerns unrelated to the macroeconomy which are implicit in Gilt yields today.
At Barclays Capital, for instance, Gilts head Euan Harkness points out that there may well be a double edged sword to the so-called rarity value of Gilts. "Going into 1999 there must be a slight concern that the Gilt market will go into a cul-de-sac if it becomes too exotic and too illiquid," he says.
This concern appears well founded enough. While it is all very well to see sterling as a diversification opportunity in a world soon to be dominated by dollars and euros, this is countered by the fact that the sterling market may become so small in relative terms following the start of Emu that it becomes peripheral to the point of being irrelevant.
The danger -- and this a theme often harped upon by Britain's Eurosceptics -- is that in spite of the contraction in the supply of UK Gilts, the competition from the much larger and more liquid government bond market in euro-land will more than compensate for this, leading to a net outflow of institutional money.
"Traditionally," says one analyst, "the UK was able to rely on a very large pool of domestic assets which were channelled more or less automatically into the Gilt market. But in the UK we have outstanding debt representing about 55% of GDP and a pension industry with assets covering almost 100% of GDP. Germany does not have anything like these assets in its pension funds, and the worry is that you will see Germany being a net beneficiary of flows of UK pension money."
All the more reason, say bankers, for the UK to ensure that it does everything within its power to maximise the efficiency of its Gilts market -- which bankers say still leaves something to be desired.
"I think we have a very good government bond market now in terms of its structure," says Boal, "but investors, especially foreign investors, still complain about illiquidity -- they still complain that the Gilt market does not give them as good a bid-offer spread as they see in the Bund market."
This, say Gilt market analysts, is primarily a reflection of enduring problems with the hedgeability of Gilt positions for primary dealers.
"A very palpable instance of where hedging has been difficult over recent months," says one, "has been the squeeze on the 09/08 Gilt.
"That arose because there was no nearly adjacent issue in terms of value which made it very easy to squeeze the 09/08 again and again because people were unable to substitute anything else for it."
This analyst adds: "The remedy for that is to change the specification of the futures contract which is what Liffe has done, but we would certainly hope that one of the main roles the new DMO will play will be to make sure that Gilt squeezes are not allowed to impair market efficiency in the future." EW