Taking stock of rates

THE INVESTOR'S VIEW/Croesus:This week, trends in the currency markets came to the forefront of investors' attention as the euro hit an all-time high of over €1.37 to the dollar.

One of the catalysts for the dollar weakness was news that Home Depot, the US DIY retailer, cited continuing reason for cutting its earnings forecasts this year. At the same time, DR Horton, the US's second largest home-builder, added to the gloom in the housing market, saying that sales orders in its third quarter fell by 40 per cent.

Despite some good news from other sectors of the economy, analysts continue to worry that the slump in the US housing market will eventually spill over into the broader economy through a weakening in consumer confidence.

Another catalyst for dollar weakness is the growing conviction that European interest rates are set to remain on an upward trend for a considerable period.

On July 5th, the Bank of England raised the British base rate by a quarter point to a six-year high of 5.75 per cent amid expectations that rates there will reach 6 per cent by year-end.

Furthermore, comments from members of the ECB's governing council reinforced expectations of a further quarter-point rise in the repo rate in September.

While the overall European economy is performing better than the US economy this year, it is notable that the housing sectors in several European markets are beginning to behave like the US housing sector.

It is, however, not a Europe-wide phenomenon, and is confined to those economies which have enjoyed housing booms over the past decade such as Spain and, of course, Ireland.

In the US, rising interest rates and a slowing economy have served to impact adversely on the housing market. In contrast, the sole catalyst for the housing slowdown in Europe would seem to be rising interest rates.

In Ireland, the news flow emanating from the housing market looks set to deteriorate further before it gets better.

The official statistics are now beginning to confirm that house prices have fallen in recent months.

Those who believed that the Irish residential market had all the hallmarks of an asset price bubble could well be vindicated over the next 12 months. Once sentiment changes in any market where prices have reached elevated levels, a downward price adjustment can be erratic and unpredictable.

One key reason for expecting the Irish housing market to remain under pressure for at least several more months is the interest rate cycle. The consensus now is that euro interest rates will reach 4.5 per cent by year-end.

Croesus has long held the view that market analysts have been far too complacent regarding the potential for much higher interest rates. Over the past year, economists and analysts have in general under-estimated the strength of the uptrend in interest rates.

Inflation is the key to future interest rate trends, and there is increasing evidence that global inflationary pressures are becoming embedded into the financial system.

Two front-page headlines from the FT this week give a flavour of what's happening.

One, "Fish'n'chip prices leap as shortages bite" told the story of how shortages in potatoes and mushy peas have pushed up the price of this traditional takeaway meal.

More pertinently, the article pointed out that demand from China and India, together with the move toward biofuels, pointed towards a long and sustained period of rising food-price inflation.

The second headline, "World will face oil crunch in five years", referred to a report from the International Energy Agency that the supply of oil was falling faster than expected in mature areas.

With medium-term demand growth underpinned from the booming economies of India and China, the ongoing tightness in the market can only result in higher oil prices.

It is these medium-term inflationary pressures that central bankers focus on when formulating interest rate policies.

For the ECB, inflationary pressures in global commodity markets, combined with strong domestic demand, could mean that euro interest rates would continue to rise in 2008.

This would be bad news for the building and construction sector, and, by implication, could be bad news for the Irish stock market.

The ISEQ overall index is now down by 1 per cent in 2007 compared with a rise of 8 per cent for the FTSE Eurofirst.

The weak housing market has been the catalyst for this weakness as investors have viewed it as a reason to sell the financial stocks given their exposure to the mortgage market. Bank of Ireland and Irish Life & Permanent have been hardest hit, with year-to-date price declines of 15 per cent and 14 per cent respectively.

The two quoted building stocks have also fallen, with McInerney down by 23 per cent, although Abbey has only fallen by 6 per cent.

In coming months the key issue for investors will be whether the fall in share prices so far already discounts the bad news, or whether sentiment will deteriorate further as the focus of attention moves towards prospects for 2008.