Rising interest rates likely to keep bond prices under pressure

Investor/An insider's guide to the market:The debate concerning interest rate trends is likely to remain centre stage among financial market participants in coming months. During the latter part of 2006, a cosy consensus emerged that was exceptionally benign in terms of its impact on financial markets.

In brief, this consensus put a high probability on an interest rate reduction by the US Federal Reserve during the first half of 2007; euro interest rates were expected to rise further but to pause at 3.5 per cent or 3.75 per cent; sterling short-term interest rates were perceived to be at a peak, while rises in yen interest rates were expected to be extremely modest.

Over the past few months, a string of economic data releases showing economic growth to be stronger than forecast has broken this consensus. The recent surprise quarter-point interest rate hike in Britain, engineered by the Bank of England, only served to copper-fasten an emerging view that global interest rates are unlikely to decline for quite some time.

In the US, the debate has shifted to how long interest rates will remain on hold, and the risk of further monetary tightening has risen. The contraction in the US housing market has had no adverse impact on overall consumer spending. In fact, in the final quarter consumer spending helped the US economy to regain momentum, with spending rising by an estimated annualised rate of 4.3 per cent in the fourth quarter, compared with 2.7 per cent in the third quarter.

There is no evidence of any material economic slowdown from data on the labour market. US hourly earnings rose by 4.2 per cent year-on-year in December and the total number at work continues to grow at a healthy pace. Lower fuel prices are also boosting consumer demand.

In the euro zone, business confidence hit a high in December, although Ger-many's VAT increase will probably have a small dampening impact in the first few months of this year. Growth in the monetary aggregates continues to receive comment from European Central Bank (ECB) board members who are worried that the rapid growth in the money supply may eventually lead to higher inflation.

Recent data showed that euro-zone money supply growth surged to a 16-year high in December. Most commentators now expect two further quarter-point rate hikes from the ECB before there is a pause at 4 per cent.

The upward shift in interest rate expectations has led to weakness in bond prices. In the US, benchmark bond yields are at five-month highs and are hovering around the psychologically important 5 per cent level. Euro-zone bond yields have also moved up so far this year and the yield on 10-year Bunds has risen to 4.1 per cent.

For the first half of the year, Investor expects bond prices to remain under pressure as yields edge higher. Indeed, there is a significant chance that global economic growth surprises on the upside this year.

There is no sign of any slowdown in emerging economies, which now account for a much higher proportion of global gross domestic product (GDP) than heretofore. The ongoing strong performance from China and India, as well as several Latin American countries, could lead to renewed acceleration in global growth if the developed economies prove to be more resilient than expected.

This scenario would have an adverse impact on bond markets and yields could go significantly higher, particularly if inflationary pressures emerged.

At first glance, the more rapid growth scenario should have positive implications for equity markets. Faster growth would lead to better prospects for growth in corporate profits. Business confidence would improve, giving more impetus to merger and acquisition activity.

However, the positive impact of stronger profits could be offset by the negative impact of rising interest rates and bond yields. Equity markets are priced to reflect a moderation in global growth, which is expected to reduce inflationary pressures. Appreciably faster growth would add uncertainty into inflationary prospects and as a result central bankers may resume raising short-term interest rates. This would result in increased volatility in financial markets from the extremely low levels reached in 2006.

Investor takes the view that the faster growth scenario is quite likely and therefore 2007 will witness higher bond yields. Yields on high-risk corporate bonds could rise steeply and this would inevitably lead to greater volatility on equity markets.

Investor still expects equities to be the best-performing asset in 2007 but the path could well involve some unpleasant surprises along the way.

Investor takes the view that 2007 will witness higher bond yields.

Yields on high-risk corporate bonds could rise steeply and this would inevitably lead to greater volatility on equity markets.

Investor still expects equities to be the best-performing asset in 2007 but the path could well involve some unpleasant surprises along the way.