Nostradamus confidently predicted that the world would end (again) on American Independence Day. Pre...
Nostradamus confidently predicted that the world would end (again) on American Independence Day. Presumably the Federal Reserve had this in mind as they made sure its eagerly awaited decision on US interest rates was announced in plenty of time for this auspicious day.
Bond investors have taken fright at the continuing juggernaut that is the US economy and the spotlight has shifted from the fixed interest investors' traditional bte noire of inflation to growth. With the US likely to expand by around 4% this year and the stock market making new highs, the bond market is worried that the Fed has not done anything to slow the economy back to a more sustainable level of growth.
So are markets justified in questioning Greenspan's ability to manage the economy? With the 10th anniversary of the US expansion looming, is it far too late to 'take away the punchbowl as the party is starting'?
The short answer is no. We believe that the Fed can once more engineer a gradual slowdown in the economy. There are signs that the housing market is already slowing, which should affect the demand for durable goods. While inflation has picked up this is mainly due to the bounce back in commodity prices from the abnormally low levels seen last autumn.
Real incomes have been stable, with the increase in spending coming largely from borrowing. Given that little progress is expected in the US stock market for the remainder of this year, the impact of the wealth effect in continuing to support consumption should be limited.
It is also important to put any prospective rises in US rates into perspective. The recent move should be seen merely as a reversal of the 0.25% point cut made as 'insurance' the last time the end of the world seemed likely. And another 0.5% point of rises would only take the Fed Funds rate back to where the last easing cycle started. This is emphatically not a repeat of 1994/95 when rates virtually doubled in seven steps.
If the US is going to come out of this in good shape why are the global markets concerned? Bond yields have risen around the world, most notably in countries where growth is struggling to emerge from recession. Notwithstanding the key role of the US in the global economy, the market reaction does strike us as somewhat overdone. Growth in the UK will only rise above 1% next year, with inflation likely to undershoot the Bank of England's target, a view we have held for some time.
Indeed, on a harmonised basis, UK inflation is actually no higher than all but four Euroland countries. Across the Channel, inflation is around 1% and growth remains below trend. Taken together none of these factors strike as supporting the current market view that short rates will rise dramatically in both the UK and Europe next year. Japan is a rather different story. Almost whichever way the economy goes it is hard to see a positive outcome for bonds.
Mark Parry is director of fixed interest at Hill Samuel Asset Management
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