LONDON, 11 July 2005 — On Tuesday June 21, the Swedish Riksbank surprised the market in cutting rates by 50 basis points. The market had been expecting a cut of just 25 basis points after the release of weak GDP figures for the first quarter. On a year-on-year basis, growth was just 1.4 percent, even though investment rose 7 percent. The key was the minimal growth in personal consumption, which grew by a meager 0.5 percent.
The Riksbank’s aggressive action may shift expectations as to what the European Central Bank (ECB) will do in its interest rate policy. So far the money markets are still pricing in no change in short-term rates for the balance of the year, though the recent drop in longer-dated bond yields suggest some investors are starting to price in an ECB rate cut.
In the United Kingdom, however, money market expectations have shifted more substantially. Weak data on personal borrowing and retail sales have encouraged the money markets to price in a UK rate cut by the end of this year.
Obviously, US rates, rather than those in Europe, have the most influence on financial markets. Since the end of March, money markets have moved away from pricing in Fed Fund rate hike up to the 4 percent region. The December three-month futures contract has traded for the most part between 96 and 96.2 since mid-April.
This range is consistent with just two more 25 basis point hikes. In other words, money markets have for several weeks been suggesting that the Fed will be done with raising rates in Mid-August by which time the Fed Funds target should have reached 3.5 percent.
How realistic is this? Considering the developments in the GDP data, 3.5 percent looks low! First quarter data shows volume growth of 3.5 percent annualized, or 3.7 percent on a year-on-year basis. In nominal terms, the respective figures are 6.7 percent and 6.5 percent. In the light of such data, the Taylor rule would imply a US short-term rate of 4.5 percent or perhaps higher.
On the other hand, job creation in the present upswing has been rather weak and, if this persists, then the political pressures for an expansive monetary policy will intensify, especially now that fiscal policy is no longer stimulative.
Recent data show little support for the notion that US inflation pressures have accelerated. The price deflator for “core” consumer spending has remained around 1.5 percent for a year now.
Moreover, low interest rates elsewhere in the industrialized world can be expected to exert some gravitational pull on US rates. If they do not, the risk would then be for a further rise in the US dollar. Consequently, this could exacerbate the huge US demand for credit from the rest of the world. All in all, it seems credible that 3.5 percent in mid-August could mark the end of Fed tightening.
The fundamental problems confronting securities markets remain much the same: A weak recovery in industrial countries and almost no growth in Europe, rising raw material costs, notably for energy, and huge trade imbalances with massive surpluses in parts of Asia and the Middle East counterbalanced by a US current account deficit in excess of 6 percent of GDP.
However, the trend in interest rates is starting to look more favorable for investment and we, at Clariden, have therefore decided to increase the equity commitment from 25 to 30 percent. This will also permit an increased exposure to emerging markets. Moreover, we are slightly extending our recommended duration in European and US bonds. On equities, we increased our exposure to emerging markets, as we believe that the trend out-performance of the last two years has further room the run. The other preferred areas remain the same and continue to advocate a broad spread of equity investments across the main industrial sectors.
Finally, on the foreign exchange front we, in principle, recommend hedging forex exposure back to the domestic currency. However, over the summer months, we do expect some reversal of the US dollar’s recent gains against both European currencies and the yen.
(Habib F. Faris is vice president at Clariden Bank, London.)
(The information contained herein is for information only and should not be construed as an offer or a solicitation to purchase, subscribe, sell or redeem any investments. While Clariden Bank uses reasonable efforts to obtain information from sources, which it believes to be reliable, Clariden Bank makes no representation or warranty as to the accuracy, reliability, or completeness of the information.)