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The themes of the previous two columns - namely, growing concerns about inflation and the change of guard at the Federal Reserve - lead to a conclusion that interest rates are likely to rise and/or keep on rising.
This conclusion has different implications for each economy and currency and, although it is uniformly negative for bond markets, has certainly not been treated as uniformly negative for equities. In the US, the raising of medium- and long-term interest rates (bond yields) stems from a consensus that short-term rates, set by the Fed, are not going to stop rising any time soon. This week, the Fed announced the by-now customary quarter-percent increase, to arrive at 4%. Many people had thought that the cycle would peak at this level, but today this seems much less certain. The message coming from the Fed, in its statements and in lectures by Fed governors, is that they intend to keep raising rates, because the economy is still strong and the hurricane damage was fleeting. Furthermore, it will spur rebuilding activity next year. In addition, the new Chairman, Ben Bernanke, is perceived as having dovish tendencies with regard to inflation, and will therefore avoid enhancing that perception by changing the tightening policy as soon as he takes over.
In tandem with this hardening of views regarding US interest rates, the markets have come to believe that the European Central Bank will raise rates very soon, probably in December. Here, too, the feeling has been nurtured by a newly hawkish line from the ECB itself, following a prolonged period of stability at the 2% level. The need to move higher stems from inflationary concerns in Europe, and the expectation of an imminent move higher in euro interest rates has raised bond yields from the very low levels reached recently.
IN THE UK, however, there is no expectation of interest rate rises, since consumer spending is undeniably weak and the housing boom has faded as a major concern. Interest rates remain high, at 4.5%, but have already been cut once - and the gap between UK rates and those on the dollar is rapidly narrowing. The result is that sterling has come under pressure and is widely expected to underperform against the euro and even the Swiss franc, both of whose interest rates are much lower but are pointed upwards, rather than downwards as in the UK.
A more extreme example of the same syndrome is Australia, where rates have long been high, but where the economy is also showing signs of weakening while the spread between local and US interest rates is narrowing. Ironically, New Zealand's economy is in much worse shape but its rates are higher than Australia's and have recently been raised, so its currency is in demand while the Aussie dollar has been falling against both the dollar and the euro.
Because of the intense focus on interest rate differentials on the part of the currency markets, by far the weakest of the major currencies in recent weeks has been the Japanese yen. Given the fact that Japanese interest rates have been at zero for the past several years, this is hardly surprising. In fact, Japanese investors have been active in selling domestic bonds and moving their money overseas to take advantage of the higher yields available on dollars and, to a lesser extent, other currencies. The stated intention of the Japanese central bank to begin pushing interest rates upward some time next year is too vague to make the yen attractive today, but it has been more than enough to intensify selling of Japanese bonds. The strong demand for yen on the part of foreign equity investors (who have been pouring money into the Japanese stock market) has not been enough to offset the outflow generated by Japanese fixed-income investors moving overseas.
So long as interest rate movements and the consequent widening or narrowing of interest rate spreads on different currencies remain the key concern of the currency markets, the dollar is likely to retain its recent strength. Only if, or when, the focus switches to economic growth rates, and the prospects of a slowdown in the US and UK while Europe and Japan pick up speed, will the dollar again come under pressure.
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