LONDON - So far, so good.
U.K. Chancellor of the Exchequer Gordon Brown's stunning move to give the Bank of England freedom to set interest rates boosted U.K. financial markets' already solid support of Prime Minister Tony Blair's infant government.
But money managers warned it is still early days, and potential dangers loom on the horizon.
Some fret that Labor's true colors might not be showing yet. They fear a rise in corporate taxation - particularly in the Advance Corporation Tax, which would hurt U.K. pension funds - to support overly optimistic budget projections, and worry adoption of the European Union's social chapter and other measures might hamper Britain's flexible labor markets.
One view is the Labor Party might have recognized that past policies have resulted in "massive job destruction," said Tony Thompson, chief investment officer for Foreign & Colonial Management Ltd., London.
The other view is that Labor officials "have learned absolutely nothing" and seek to impose "a good solid French bureaucracy in Britain" and "put up a tariff wall," he added.
So far, financial markets are pleased with the new government's first actions.
Mr. Brown won kudos from the markets last Tuesday by giving the Bank of England freedom in setting interest rates - although in line with inflation targets set by the Treasury - and by raising the base interest rate by one-quarter of 1%.
These moves firmly established the government's commitment to fight inflation, easing fears Labor would slip back to its old ways.
On May 6, the 10-year gilt rose more than two points, closing at 101.188. On the back of the interest-rate reforms, the Financial Times-Stock Exchange 100 index rose 63.7, hitting a record close of 4,519.3.
The interest-rate hike "took away worries" the new government would be soft on inflation or would pursue a "tax-and-spend" policy, said Charles Plowden, a senior fund manager at Baillie, Gifford & Co., Edinburgh.
"It's a good sign that he (Brown) is willing to do the right thing and do it fast," said Mark Hays, executive vice president at IDS International Inc., London.
Some observers also wondered whether the policy shift indicates a desire to join European Monetary Union. But the government's announcement stops short of the Maastricht Treaty requirement that the central bank be entirely independent of the government.
What's more, Labor officials have said it is unlikely Britain would join EMU in the first wave, scheduled to start Jan. 1, 1999.
The Blair government, however, has signaled its desire to have far more open discussions with European Union officials - in contrast with the frosty relations that developed during the Conservative Party's 18-year reign.
A more pro-European government is a positive for the U.K. gilt market. The possibility of joining a single currency will narrow interest-rate spreads between Britain and Germany, experts said.
While granting independence to the Bank of England already caused the U.K. yield curve to flatten, there still exists a 230 basis-point spread between the 10-year benchmark gilt and the 10-year bund.
An argument for convergence of bond yields becomes "very powerful," Mr. Hays said.
Dick Howard, senior economist at Julius Baer Investments Ltd., London, said: "If there's a prospect of the U.K. joining the single European currency, we should see inflation rates (converging) a bit more.
However, some managers believe a friendlier attitude toward Europe does not mean Labor will buy EU policies hook, line and sinker. Openness toward Europe "does not imply a wholesale reversal of policy," Mr. Plowden said.
Even if the Labor government ultimately decides to join EMU, they probably wouldn't want to do so at today's exchange rate. Sterling has appreciated about 20% against continental currencies in the past year.
At 2.82 deutsche marks to the pound, it is close to the level at which Britain had joined the Exchange Rate Mechanism, which fell apart in 1992. A level closer to 2.6 would be better if Britain enters the single currency, Mr. Howard said.
While money managers welcomed greater freedom for the Bank of England, some also warned this could lead to a tighter fiscal policy, as the government has yielded one of its two major tools for managing the economy.
Combined with overly optimistic assumptions on economic growth and government spending, some think the new government might propose new taxes on business, possibly in Mr. Brown's interim budget, which is expected in early July. Labor campaigned on imposing a windfall tax on privatized utilities, but the question is how much further it will go in drumming up new revenue.
John Murray, head of U.K. equities at John Govett & Co. Ltd., London, said yielding the reins on monetary policy "does open the opportunity that we could get a tighter fiscal policy."
In particular, many financial experts are worried Mr. Brown will target pension fund tax benefits, particularly the Advanced Corporation Tax. Tax-exempt institutions receive a 20% credit on corporate dividends. Many fret the new government will seek to eliminate or reduce that tax relief, effectively reducing dividends.
Some argue such a move actually would be revenue neutral. Because U.K. pension funds value equities on the basis of their future income stream, trimming ACT would cause British pension funds to be less well funded. That could force some companies to boost their pension contributions - thus reducing pre-tax profits.
Such a move not only would hurt pension fund valuations, but could dampen U.K. equities by making bonds appear relatively more attractive. U.K. tax-exempt institutions are estimated to own 60% of British shares.
In addition, some worry the government would reduce the rate at which pension contributions are deducted to the base of 23% from 40%, and would restructure capital allowances.
Labor officials so far say they have not proposed such measures - nor have they ruled them out.
While many U.K. managers think the domestic equity market is too frothy, IDS' Mr. Hays thinks a lot of cash could be reinvested in the stock market if the new government gets its policies right.
"We think cash may come back in," said the manager, which has fully weighted U.K. equities for international portfolios.
While Britain is further along in the economic cycle than either continental Europe or Japan, Mr. Hays said the U.K. market could follow the United States' example, which has shocked European investors during the past two years.