RIYADH, 28 June 2004 — The week ahead will see two key events unfold, the first one political and the second one economic. On the political arena, the US is determined to handover political power to the Iraqis on June 30. Although, there is substantial difference in opinion among the parties involved — the US views it as the beginning of a new chapter in Iraq, while its opponents see it as more of the same — it certainly will create a new set of circumstances on the ground that is likely to increase uncertainty in and around the region.
Markets are concerned about it because it affects oil price, risk-premium on financial assets and safe-haven activity. On the economic front, the key future-shaping event will be the US Federal Reserve’s Federal Open Market Committee (FOMC) meeting on June 29-30. It is almost universally expected that the Fed will raise its key federal funds rate by 25 basis points (bps) to 1.25% on that date.
While there is disagreement about the size of the increase — according to the Chicago Board of Trade (CBOT), where federal fund futures are traded, markets are pricing in a 100 percent probability that the FOMC will increase the target rate by at least 25 basis points and a 6% probability that the increase will be 50 bps — almost everyone agrees that this move will herald the end of the US Fed’s 2-year policy of extra-low interest rates and the beginning of a cycle of interest rate hikes that will make credit more dearer over time.
Global financial markets had been treading water for the past three months due to the uncertainty related to the Fed policy. In the US, the blue chip Dow Jones has been range-bound below 10,500, and the NASDAQ has been bobbing up and down around the 2,000-mark. Japan’s Nikkei has been around the 11,500-mark, the UK’s FTSE, around the 4,500-mark; and Germany’s DAX, around the 3,900-mark in the past three months.
In the past few weeks, as expectations of the Fed’s policy settled on the 25 bps number, markets have moved up. The Dow has gained 434 points from its bottom of 9,938 reached on May 20; the NASDAQ, up 148 points from its bottom of 1,877 on May 17; the Nikkei, up 1,275 points from its low of 10,505 on May 17; the FTSE, up 91 points from 4,403 on May 17; the Dax, up 206 points from its low of 3,710 on May 17 (Note how all the markets had their lows at the same time — a remarkable exhibit of US led globalization!).
What does this imply about the market’s direction after the Fed decision? Although, market moves have been contradictory recently, stock valuation models suggest that, normally, if the Fed move turns out to be stronger than anticipated, we would expect some market correction (this would imply that the Fed is more concerned about inflation than the market assumed and will tighten policy faster).
(Khan H. Zahid is the chief economist and vice president of Riyad Bank.)