Euro-zone interest rates likely to continue upward trend in 2007

Investor/An insider's guide to the market: Short-term interest rate trends in Europe and Britain are still firmly set on an upward trajectory. Comments from the European Central Bank (ECB) suggest that a further 25 basis point rise in the repo rate to 3.5 per cent is almost certain at its December 7th meeting.

Jean-Claude Trichet was not particularly forthcoming concerning policy action going into 2007. However, the tenor of the ECB's remarks continue to be hawkish and suggest that if the euro-zone economy continues to grow at current rates, short-term interest rates will rise further in 2007.

Survey data from Europe continues to support the view that the European economy will perform well going into 2007. The purchasing managers index (PMI) of conditions in euro-zone manufacturing industries rose to 57.0 in October, from 56.6 in September, which is a level that indicates ongoing firm growth.

German government figures show that German labour market conditions are continuing to improve. In October the unemployed total fell by a greater-than-expected 67,000 and the unemployment rate improved to 10.4 per cent from 10.6 per cent in September.

Better economic conditions in Europe over the past year have yet to stimulate an across-the-board improvement in consumer confidence and spending. Consumers in the euro zone's largest economy, Germany, have yet to start spending and their confidence is still at a low ebb, according to survey data.

However, official confirmation that the European economy has exceeded expectations this year came from European Commission forecasts released earlier this week. The commission is forecasting economic growth of 2.6 per cent this year and 2.1 per cent next year for the 12-member euro zone. For the wider 25-nation EU, the forecast is for growth of 2.8 per cent for 2006 followed by 2.4 per cent in 2007.

The commission expects EU growth to hold steady at about 2.4 per cent in 2008, which is considered to be close to the long-term trend rate of growth. These forecasts reinforce Investor's view that official euro-zone short-term interest rates will reach 4 per cent by the middle of next year.

In the US, views regarding the next move by the Federal Reserve continue to whipsaw depending upon the latest piece of economic data. (A whipsaw occurs when the market does the opposite of what is expected.) Last Friday's employment report for October generated another sharp swing in sentiment back towards the view that the Federal Reserve will keep US rates relatively high for the foreseeable future. Upward revisions to the previous month's data revealed that in the three months to October, US companies created 470,000 jobs and the US unemployment rate fell to a cyclical low of 4.4 per cent.

The report did confirm weakness in construction and manufacturing, but activity in the services sector acted as a strong counter-balance. The news sent yields higher in the US bond market as the money market yield curve shifted upwards to reflect revised expectations that the Fed will hold the Fed Funds rate steady at 5.25 per cent for the foreseeable future.

Investor expects US interest rates to remain unchanged for the first half of 2007, with an increase in rates marginally more likely than a decrease.

Meanwhile, corporate earnings reports provide a positive stimulus to equity markets. In the Irish market, Ryanair reported second-quarter financial results on Monday that were ahead of market expectations. Earnings per share (eps) rose by 22.8 per cent due to strong passenger growth, favourable yields and ongoing growth in ancillary spending. The company is now guiding profit growth of 16 per cent for the year compared with earlier guidance of 11 per cent.

Increases in fuel costs exerted upward pressure on unit costs but the tide has turned in the oil market and Ryanair has been progressively hedging forward its fuel requirements at prices considerably lower than those incurred this year. In Investor's view there is a real possibility that Ryanair will do much better over the winter months than is currently forecast so the share price is likely to maintain its recent good form.

Not surprisingly, media attention has focused on the Aer Lingus takeover battle, as it becomes increasingly likely that Ryanair will not succeed in gaining control. Ryanair can comfortably afford to hold its minority stake for the long term. The astute timing of the purchase of the stake means that Ryanair bought at a favourable price. Furthermore, and somewhat ironically, this minority stake makes it well nigh impossible for any other airline to mount a takeover bid for Aer Lingus.

However, the financial results serve to re-emphasise that the Ryanair low-cost model of air travel continues to attract ever more passengers and to deliver high returns to its shareholders.

Official euro-zone short-term interest rates will reach 4 per cent by the middle of next year. US interest rates are likely to remain unchanged for the first half of 2007, with an increase in rates marginally more probable than a decrease.