US interest rate trends make markets nervous

FOR better or worse, the Irish as well as the British and German markets broadly follow what goes on in New York.

As a result, Mr Alan Greenspan, the chairman of the Federal Reserve in the US, is the most influential person in determining the direction of interest rates and hence bond and equity markets.

While the quarter point rise in US rates last week was well signalled, there is now a feeling that the Fed could deliver a lot more. The initial inertia which greeted the announcement has grown somewhat feverish.

Wall Street has suffered two days of heavy losses and long-term interest rates in the US are rising rapidly. Having fallen 140 points on Friday, the Dow Jones index fell another 157 on Monday before recovering 27.57 points yesterday.

At the same time, long-term interest rates in the US are now above 7 per cent, well above the yields of 6.5 per cent seen in mid-February. Many analysts now believe that the Fed would be happy to see them at 7.25 per cent to 7.5 per cent.

Analysts are pointing to the last period of interest rate rises in the US when the Fed raised rates seven times. Although significant rises in long-term yields could obviate the need, the US economy is highly dependent on long-term financing and the rises in the 30-year bond could limit the need for much further tightening by the Fed.

Nevertheless, there is already a growing consensus that rates will be raised a further quarter point when the Fed meets in May. However, there is some argument about whether this will be the end of the current round of rises.

Mr Jim Power, chief economist at Bank of Ireland, believes that the situation is fundamentally different this time round.

"The Fed is much further ahead of the cycle this time," he says. "Another quarter or half point rise will be enough."

The unease is due to continuing evidence of a very strong American economy. Personal income growth in February is up, indicating no slowdown in consumer spending. The release of the National Association of Purchasing Manufacturers index also showed very strong growth.

However, it is the employment numbers which have been most influential. Almost 339,000 new jobs were created in February after 247,000 in January. March figures will be released this Friday and the markets are likely to remain nervous ahead of the critical data.

The headline increase in job numbers is expected to be around 190,000. Anything stronger than that is likely to increase anxiety, according to Mr Power. However, a weak figure of 160,000 or less would set rate expectations back a little, he adds.

The fear is that strong economic growth will lead to higher inflation and even higher interest rates. The market could also be using higher rates as an excuse to pause for breath and take some profits, Mr Power says. He does not believe it is the beginning of a sustained downward movement.

The equity markets have been affected because of fears that higher interest rates will, weaken corporate earnings. The correction in technology stocks in the US is also high-lighting fears.

The Nasdaq index has fallen over 9 per cent since the beginning of January. Many analysts are also concerned that interest rate raises will bring a slowdown in corporate investment.

There is also growing concern among some investors that, on the basis of pure fundamentals such as earnings and dividends, the New York market is trading at unrealistic levels and is due a correction.

For European stock markets, any fall-out in New York will inevitably follow through and prices will take a tumble. If the correction in New York is the result of a hike in interest rates by the Fed, then it will probably be the major financial shares, which tend to trade at a differential with bond yields, that will take the hit.

Rising bond yields mean a fall in bond prices. So, if bond prices fall, then bank shares will follow to maintain that yield differential.

Overall the US markets are supported by all the positive factors which drove it forward last year and above all the economy is continuing to grow with little evidence of inflation. In addition, there are still considerable inflows of new money from mutual funds while foreign investors are continuing to invest in US Treasuries or bonds