US interest rates are arguably one of the single most important variables in global markets and unti...
US interest rates are arguably one of the single most important variables in global markets and until recently the direction of US interest rates have seemed to be on an unstoppable upward trend, with a steady pattern of quarter point increases for some 18 months to reach their current level of 4.25%.
However, Paul Niven, head of asset allocation at F&C Asset Management (London), says although markets anticipate further tightening, the end appears to be in sight with the minutes of the last Federal Open Market Committee (FOMC) meeting, where interest rates were raised by 0.25%, giving a clear indication of this.
He explains: "The bottom line is US interest rates look like nearing the top of the cycle, inflation appears to be peaking earlier than previously anticipated, worries about longer-term price pressures have materially reduced and the Federal Reserve Bank has revised down growth expectations for 2006."
For financial markets the picture is also positive despite the unusual behaviour of bond markets during this tightening cycle (longer-dated yields declining as short rates rise), Niven claims.
However, he believes markets should remain cautious, with the appointment of a new chairman to the FOMC. Ben Bernanke, who takes on the role at the FOMC in March, could stamp his own mark on the market and should the scenario of slowing growth and moderating inflation turn out to be premature then rates could once again be destined to head higher.
A second risk this year stems from the recent inversion in the US yield curve, a phenomenon that many commentators have brushed aside, Niven adds.
Historically, changes in the US yield curve have been one of the most useful leading indicators of future growth and recession in the US economy.
Niven says: "Although we do not believe recession is a near-term possibility in the US, a peak in interest rates would be symptomatic of a more challenginggrowth environment. On balance, the outlook for asset markets remains constructive and a near-term peaking in Fed funds is net positive, but rate cuts in the US seem a distant possibility so investors should temper their exuberance at this early stage in the year."
However, John Kelly, head of client investment at Abbey, says one of the main threats to the current bond market, is the prospect of falling interest rates.
"The reason why lower rates threaten bond investors is because a strong dollar has been a critical factor stabilising bond prices. Historically, currency market volatility has been greater than the volatility of bond markets, keeping most bond investors in their domestic market.
"But recently, currency markets have enjoyed the cosy harmony of a strong, higher-yield dollar and a weaker euro and yen. This has reduced fluctuations and encouraged bond holders to look for opportunities in international markets - in US dollar-denominated emerging country debt and in the corporate bond market, where the US depth of choice is much greater than that available in the UK."
But, Kelly says falling US rates and a weaker dollar threaten this stability, leaving income-seeking bond funds exposed and with a difficult choice between a defensive retreat and remaining in a challenging environment that will be uncomfortable for many holders.
"Key to this is the US housing market. The US consumer has seen rising house prices not just as a source of increased wealth but as a source of increased spending power. Low interest rates have encouraged equity withdrawal and the spending of these sums has created a consumer boom much greater than the low job growth/low wage growth environment could ordinarily sustain."
Possibility of further interest rate rises
Positive outlook for bonds in 2006
Interest rate changes could threaten stability of US consumer
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