Small upside surprises outstrip impact of interest rate rises

Investor: Interest rates have recently been creeping back up towards the top of the agenda of issues that are of concern to participants in the financial markets. Markets have not been hit with any major surprises, although there has been a gradual build up of what could be described as "mini-surprises".

The Bank of Japan announced that it was finally bringing to an end its policy of flooding the Japanese money market with excess liquidity. This does not mean the immediate abandonment of the zero interest rate policy, but it is now only a matter of time before Japanese official short-term interest rates move back into positive territory.

In the US, the new Fed governor, Ben Bernanke, has moved seamlessly into his predecessor's footsteps with an expected quarter point increase in the Fed funds rate at its latest meeting. There was no change in the Fed's rhetoric, which suggests that a further quarter-point rise is likely at its next meeting to bring the Fed funds rate to 5 per cent.

Up to recently, most financial analysts expected 5 per cent to mark the peak for US rates in this cycle. Now, many are not quite so sure as economic data show that the US economy is still growing strongly. According to the Fed, the risks to inflation and growth remain evenly balanced.

Perhaps the most significant mini-surprise concerns developments in Europe. Most forecasters have been predicting a modest improvement in European growth prospects for 2006. There have, however, been a number of false dawns in Europe in recent years and, consequently, economists have learned to temper their optimism.

Nevertheless, the evidence is mounting that this time the European economic recovery is for real. In particular, business and consumer confidence indicators have continued to surprise analysts on the upside. The European Commission's indicator, released last Friday, revealed that economic sentiment (an index which combines assessments and expectations from business and consumer surveys) rose last month to its highest level since June 2001.

There were several sectors that exhibited increased confidence such as retail, construction, manufacturing and service sectors.

The purchasing managers' index of activity in euro-zone industry was also stronger than expected in March, rising to its strongest level since September 2000 at 56.1 from 54.5 in February. Both the German and the French indices were particularly strong.

Expectations regarding the pace and eventual magnitude of European Central Bank (ECB) interest rate rises have been moving steadily upwards in response to the better economic tone in Europe. This is now reflected in a much steeper money market yield curve. On the wholesale money market, the six-month euro rate is now 3 per cent and the one-year rate is very close to 3.25 per cent.

This upward pressure in the money market has also been felt in the euro-zone bond market, where the 10-year euro bond yield has now moved up to 3.82 per cent, which is its highest level since late 2004.

Developments in Europe have acted to reinforce the general upward trend in global bond yields. The 10-year US treasury yield is currently at 4.87 per cent, its highest level since mid-2002.

In 2005, equity markets rose strongly, even though US interest rates were rising. A major positive factor was the fact that US bond yields were virtually static in 2005, while euro-zone yields declined marginally. In contrast, if current trends persist, 2006 will be a year of rising global bond yields. This would normally be viewed as negative for equity markets. Yet equity markets have continued to storm ahead during the first three months of 2006, despite rising interest rates and bond yields.

Strong and synchronised economic growth in all the major economic blocs is the main explanation for this positive momentum. So far, growth in output and profits has been sufficiently strong to easily outstrip the negative impact of higher interest rates and bond yields. Investor takes the view that global economic growth will continue to be sufficiently strong to enable the equity bull market to continue for most of 2006.

Despite recent rises, interest rates and bond yields are still low in a historical context, and the projected rises are not sufficiently large to derail the positive underlying economic fundamentals. Barring shocks, 2006 should be a year of strong share prices gains, but weak bond markets.