Recent events suggest interest rates decline

The past few weeks have witnessed a culmination of events all of which have increased the likelihood that interest rates worldwide will be declining over the next six-12 months.

The US Federal Reserve clearly signalled its rising concerns about recessionary risks on Tuesday when it cut US short-term interest rates, for the first time in three years, by a quarter of a percentage point.

The collapse and subsequent bailout of one of the US's largest hedge funds highlights that financial markets contagion is not just confined to Asian and Latin American economies. Continued financial and stock market turbulence poses an ongoing risk to the global financial system and as such will encourage policymakers to lower interest rates.

In Germany, the election of a left-leaning Social Democratic government virtually ensures that German interest rates won't rise in the run-up to monetary union. Mr Gerhard Schroder, Germany's chancellor-designate, has highlighted the need to reduce Germany's high unemployment rate. His likely finance minister, Oskar Lafontaine, is arguing for setting target zones for global currencies and reining in excessive financial speculation.

Interest rates and bond yields throughout the world have been hitting historic lows throughout the current market turmoil (see table) and since end-August very low bond yields have fallen even further. Irish 10-year bond yields are now under 4 1/2 per cent.

Within the EU, interest rates are now certain to converge at lower German levels. In recent weeks countries with higher short-term interest rates such as Spain, Italy, Portugal and Ireland have been coming under increasing pressure to begin the process of convergence sooner rather than later. The European Central Bank is anxious to ensure a smooth run-in to the start of monetary union and wants anomalies such as very high Irish short-term interest rates to be swiftly smoothed.

The Irish Central bank is continuing to drag its feet regarding interest rate reductions as it tries to control the booming Irish economy. However, expectations are now so firm regarding lower interest rates that the policy of maintaining short-term rates at higher levels for any longer will probably have no effect on domestic demand.

An environment of declining short-term interest rates is usually one that is positive for equity markets. Although interest rates tend to decline in an environment of slowing economic growth, investors tend to look beyond current problems on the assumption that lower interest rates will act to stimulate economic growth. Is this likely to happen in the current environment?

There are already signs that stock markets are stabilising after the sharp falls of recent months. Although day-to-day movements have witnessed sharp gyrations in stock market indices there has been a perceptible stabilisation if one looks at weekly movements. A significant factor acting to underpin equity values has been declining bond yields and expectations of lower short-term interest rates.

The sharp fall in share values has pushed up the dividend yield on equities. Therefore, a comparison of dividend yields on equities versus lower bond yields, shows that relative to bonds, shares now offer good value. Of course this will only translate into much higher share prices if companies can grow their dividends.

In this regard the short-term omens are not particularly good. The list of companies announcing profit warnings has been lengthening at a rapid pace. Profit warnings have come from both large and small companies. One of the world's largest consumer companies, Coca Cola, issues a warning that sales growth had slowed dramatically throughout the world leading to a sharp fall in its share price. Closer to home, the Irish-based software company, CBT, saw its share price plummet as it announced much softer sales growth in Europe.

Slower growth worldwide means that more companies will announce disappointing profits performances. In the absence of a slide into outright recession declining interest rates are likely to be sufficient to prevent further sharp falls in overall equity market indices. However, a resumption of the bull market will probably have to await firm evidence that the world's economic trouble spots of Asia, Russia and Latin America, are resolving some of their fundamental economic imbalances.