LONDON, 7 June 2004 — Economic data point to a rise in US interest rates over the next eighteen months. The statement released following the FOMC meeting on May 4 recognized as much. “Although incoming inflation data have moved somewhat higher, long-term inflation expectations appear to have remained well contained .... At this juncture, with inflation low and resource use slack, the committee believes that policy accommodation can be removed at a pace that is likely to be measured.” In other words, interest rates are going up, but slowly.

The FOMC next meets at the end of June and again on Aug. 10. Our suspicion is that a move of more than 25 basis points on each occasion would be inconsistent with the latest statement (but, of course, a bigger hike is not impossible). Moreover, as G-7 finance ministers have only recently appealed to OPEC to increase oil production (fearing an economic slowdown), it seems unlikely that the Fed would want to increase the risks of slow down by seriously upsetting financial markets. The other 2004 FOMC meeting dates are Sept. 21, Nov. 10 (one day after the presidential election) and Dec. 14. Because of the impending election, it seems likely that, following the August meeting, the FOMC would not again feel able to hike rates until December.

Experience tells most analysts to be cautious in making interest rate forecasts. But we see a good chance that the Fed funds target will be no higher than 1.5 percent throughout the next 6 months, even though rates may well rise during 2005. On this basis, bonds have some scope for a rally. A yield spread of over 300 basis points — based on the current 10 year yield of 4.75 percent — will always tempt some bond investors to extend maturities and trade up the curve once they feel that the near-term interest rate outlook has stabilized.

This is one argument behind our view that there will be a decent rally for markets over the next three to six months. There are other supports to this bullish view of the near-term. The most important are economic — namely that the global recovery is continuing with, so far, not much impact on inflation rates. A second point is that markets are technically “oversold”, with many investors sitting on higher cash positions than normal.

Equity market gains in 2003 were driven by cyclicals and “recovery” stories. A change now appears to be underway. Our sense is that markets are moving to discount some sort of slowdown, or at least slower growth. We retain our enthusiasm for energy, although positions have been pared back. Investors have yet to adjust to the higher oil prices, which we now expect over the medium term. Elsewhere, we look for above-average returns in biotech, the Tiger markets of the Asian Pacific and in IT.

As for asset allocation, we reduced the equity exposure to 25 percent, from 30 percent, at the start of May. This may be increased in coming weeks as we still expect a summer rally. Otherwise our policy is unchanged. Rather than allow a cautious approach to both bonds and stocks be reflected in a large, low-yielding commitment to cash, we continue to have a substantial commitment to relatively low-risk alternative investments.

We also continue to favor credit risk as opposed to duration risk. Bond exposure remains focused on shorter-dated maturities. We have adjusted the allocation in a more conservative direction over the last month, with a switch within longer-dated bonds out of the investment grade corporate area and into government bonds. Finally, the heavy financing needs of the US, evident in both the budget and the current account deficits, suggest that the US dollar will be a weak currency over the longer-term. However, given the much faster US growth rate in prospect for 2004, relative to Europe, we no longer predict that the dollar will decline over the next few months.

(Habib F. Faris is vice president at Clariden Bank, London.)