UK, Dutch bonds shrug off rate rises

BONDS

Interest rate rises are usually bad news for bond holders. Not in the UK and the Netherlands, though - the only two countries to have raised rates in Europe recently. Their government bonds have risen because investors don't see rate increases as a sign that inflation is about to speed up.

Both countries raised rates in the past five months; the Dutch on Monday for the second time in less than a month. Even so, the Netherlands has some of the lowest 10-year bond yields in Europe, while the UK's 10-year borrowing cost has fallen half a point in the past six months.

In neither country do investors see rising central bank rates as a signal that inflation will erode the value of their bonds.

"In both cases, the rate rises had nothing to do with the central banks worrying about the kinds of things the bond market worries about," said Alison Cottrell, international economist at PaineWebber International.

The Netherlands has the highest economic growth of the countries expected to qualify to join the single European currency in 1999. At the same time, it has one of the lowest inflation rates. That combination cuts the government's borrowing needs and underpins bonds.

The Dutch central bank's moves to raise official interest rates, pushing its special loan rate to 2.9 per cent, has not changed that outlook. Investors see the rises as signals of the bank's desire to stem the guilder's 0.4 per cent fall against the mark.

"I don't think there's any problem with inflation - it's a problem with the guilder against the mark," said Ronald Balk, senior bond manager for Robeco in Rotterdam .

In the UK, investor scepticism about the Government's commitment to keeping inflation low has left 10-year bond yields 170 basis points higher than those in Germany, Europe's benchmark market. Nevertheless, concern that the Bank of England would persuade the Government to raise rates has been allayed in recent months. Increases in both consumer and producer prices have been low.

UK bonds maturing in seven to 10 years have yielded a total return of more than 2.7 per cent this year in sterling, the third best performing European market for such bonds. Bank of England Governor Eddie George said last week he expects the UK to hit its 2.5 per cent inflation target, and that "inflation probably will stay around that level."

That has helped push expectations for interest rates by June down to 6.36 per cent. "The market is more convinced that rates won't go up that much this year," said Tony Norfield, treasury economist at ABN Amro.

Eurostat, the statistics unit of the European Commission, said last week that the UK annual inflation rate is 2.1 per cent, and the Dutch rate 1.8 per cent. Both easily beat the 2.67 per cent target calculated by Eurostat for joining the single currency in 1999.

Dutch inflation is staying low even though the country's gross domestic product grew 2.7 per cent last year, almost twice Germany's 1.4 per cent rate. Monday's rate increase, the second in two weeks, was "all pretty predictable, so nobody fell off their chair", said Jop Werle, portfolio manager at Kempen & Co. Copyright: IOS & Bloomberg