Fed rates rise expected

Investor/An insider's guide to the market: Just when it seemed as if the consensus view was settling on the expectation that the US Fed Funds rate had entered a period of stability, a recent survey of fund managers conducted by the Financial Times reveals that a substantial number of US fund managers believe the Federal Reserve will resume increasing interest rates in the next six months.

More than 40 per cent of the 93 fund managers polled by Thomson Financial between August and September said that they expected rates to increase from the current level of 5.25 per cent sometime over the next six months. Nearly 38 per cent of the investors surveyed, who manage a total of $4,200 billion of assets, said that rates would remain unchanged, with 20 per cent expecting a decrease.

These results run counter to the view that the recent equity market rally has been mainly fuelled by expectations of stable or lower interest rates. Rather the results of the survey support the view that it is expectations that economic growth will remain strong, thus fuelling corporate profits growth that is driving up share prices.

Most fund managers were surveyed after the August 8th Fed decision to leave interest rates unchanged after almost two years of regular incremental quarter-point rate increases. Despite this pause, fund managers are clearly worried that US interest rates may yet have to rise again in order to contain nascent inflationary pressures.

Turning to the British economy, a similar picture emerges, except that the Bank of England's most recent move was an unexpected quarter-point hike it its base rate to 4.75 per cent.

A recent flurry of statistics indicates that the British economy is running very close to full capacity. Core inflation in the UK has remained stubbornly high. Third-quarter GDP growth came in at 2.8 per cent in the year to September. This makes it the fourth consecutive quarter of growth at slightly above the trend rate of growth.

If this rate of growth is sustained, and if retail price inflation stays near its current level, it could generate upward pressure on wage and salary inflation.

Monetary tightening would clearly be the response from the Bank of England. Current expectations are for a further near-term quarter-point increase in base rates to 5 per cent, and therefore UK interest rates significantly in excess of 5 per cent in 2007 is now a real possibility.

From an Irish perspective, developments in the UK are not as relevant as they once were due to Ireland's membership of the euro zone. However, movements in the euro/sterling exchange rate continue to have a significant impact on trade and investment flows. When sterling entered the old Exchange Rate Mechanism in 1990, it was allowed to fluctuate by 2.25 per cent either side of a central rate. Some analysts have pointed out that this total band of 4.5 per cent is similar to the market-determined band that sterling trades in today.

Over the past three years the volatility of the euro/sterling exchange rate has declined steadily and during 2006 sterling has settled into a tight range, fluctuating in a 5 per cent valuation band.

A key factor in the greater stability of the sterling exchange rate is the independence of the Bank of England. Market participants are now far more confident in the inflation-fighting credentials of the UK authorities. There has also been a degree of convergence in the UK and euro-zone economic cycles in recent years.

If the volatility of the euro/sterling exchange rate is sustained at relatively low levels, there is a case for holding some deposits in sterling given the higher interest rates on offer.