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Improving economies will push rates higher Back  
Interest rates in the Eurozone, UK and US are set for an upward trajectory say economists.
Niall Dunne, treasury economist, Ulster Bank Financial Markets
It’s easy to forget that disinflation and deflation dominated American economic discussion as recently as July, since recent American economic releases have been so positive. But the Fed’s fear of disinflation was real - so real that they actively discussed buying long dated US government bonds, which they argued would lead to cheaper borrowing costs for corporates and consumers in the US.

But the bond market took this discussion as a sign of intent, and bond prices rallied sharply, in anticipation of price-insensitive Fed demand. When Fed Chairman Greenspan subsequently ruled out the possibility of the Fed buying bonds in his July testimony to Congress, the bond market fell and yields rose rapidly.

Thanks to the improved international economic outlook, and because of the volatile American bond market, yields have risen sharply, and so too has the cost of borrowing. But we felt that the euro yield curve did not offer good value out to 5 years at levels seen in May, and at current levels we believe it offers even worse value. The implied forward curve currently suggests that euro rates will rise to 4 per cent in just over 2 years, despite the fact that the Eurozone’s heartland is currently in recession, and looks set to record below trend growth for at least the nexxt 18 months.
We feel that yield curves would not be so steep at present were it not for the misunderstanding between the Federal Reserve and the bond market. So once again we do not recommend fixing exposures at present levels at the front-end of the yield curve, particularly in the Eurozone, which is likely to lag the global economy in any developing recovery.

However, for those seeking insurance, we once again suggest that caps merit consideration, particularly step-up caps, where the interest rate you are protected against moves higher over the life of the cap. Eventually yieldd curves will move higher, even in the Eurozone, but this will not happen until Central Banks start to indicate that interest rate increases are on the way. Both the Fed and the ECB have clearly stated that no increases can be expected until mid-2004, so yield curves hopefully should flatten in the interim, offering better value for those looking to fix exposures.

Noel Griffin, associate director, Treasury & Investments, Bank of Scotland (Ireland)
Most industry commentators have correctly predicted that long-term interest rates would rise over recent months. What has been surprising is the speed at which euro, sterling and dollar rates have increased over the same period. Clearly, the market accurately predicted that interest rates were at, or were close to, their low point in the first quarter of 2003.

While there exists an undoubted upward trend in interest rates, the gap between official interest rates and, for example, five-year fixed rates is wide enoughh to conclude that either short-term interest rates must rise quickly, or long-term interest rates are unlikely to rise much further. I believe the latter is the case.

Interest rates fell in the first place because of a slowdown in economic activity, to the point of near recession in some territories. As we are now seeing improved growth, stronger equity markets, and increasing customer confidence, one can reasonably expect increased interest rates. However, I don’t expect to see dramatically higher official interest rates as inflation is likely to remain very low and also the recovery will need to be demonstrably on a sound footing.

With regard to hedging, I believe short-term interest rates will remain relatively low for some months, even though long-term interest rates are unlikely to fall. As always, I believe that borrowers should fix at least some of their borrowings to insulate themselves from any sudden increase in interest rates. For example, a borrower could choose to fix 25 per cent of a loan every six months for a period of three years. This effectively protects against any rise in interest rates as well as providing the borrower with positive opportunities, should rates fall. Alternatively, caps and collars can be used as a form of insurance against higher rates, whilst also allowing the borrower the potential to benefit from a sustained low variable rate environment.

Austin Hughes, chief economist, IIB Bank
Signs of an improvement in the world economy in the past couple of months have prompted a quite dramatic change in market sentiment in regard to the outlook for interest rates. While most forecasters had expected some upward pressure on term rates to become established before the end of this year, the speed and scale of the move in term rates in the past four months is far greater than I, for one, had expected.

It should be remembered that the rise in period rates has come in spite of the delivery of summer cuts in official rates by the Fed, the ECB and the Bank of England that I had expected. These have been followed by a battery of comments that suggest initial increases in official rates are still some considerable distance away. These deeds and words have been largely lost on markets driven by the ‘big’ story that the economic cycle has begun to turn upwards, so higher interest rates are bound to follow. I don’t think interest rates need follow quickly. This is because the pace of economic growth will not be sufficient to threaten higher inflation. Indeed, I think inflation will fall towards the end of the year. So, I see scope for further cuts by the ECB and the Bank of England in late 2003 and I wouldn’t entirely rule another easing by the Fed if US economic growth falls back after an outsized third quarter gain.

I do expect Central Banks to begin to raise rates in the in the second half of next year as stronger growth should become established. Initially, yield curves should remain fairly steep but eventual central bank tightening; fairly modest growth and subdued inflation should cause a flattening through the course of 2004. Because I think official rates will rise smartly in the second half of next year, I think borrowers should begin hedging now and use any temporary easing back in period rates later this year to cover out exposures completely.

Colin Hunt, research director and chief economist, Goodbody Stockbrokers
The United States is in the vanguard of the West’s economic recovery with Euroland assuming its now almost traditional roll of cyclical laggard. With US GDP growth set to comfortably outstrip trend levels in the second half of the year, the Fed is bound to start to contemplate raising interest rates from their current emergency setting.

However, US policymakers are not going to repeat the mistakes of their Japanese counterparts who believed their own forecasts of recovery in the early 1990s, tightened pre-emptively and brought a fragile recovery to an end. The Fed will wait until it is certain that the recovery is sustainable and is likely to arrive at that judgement on the back of labour market developments. We see the jobless rate moving back towards 5.5 per cent by mid 2004 and believe that this will be sufficient to provoke the start of a rapid tightening on the part of the Fed as policy rates move back to neutrality by end 2004.

We are forecasting that the Bank of England will keep interest rates on hold through the middle of next year as the impact of weak domestic disposable income growth is countered by an improving global environment. However, the pace of the international recovery and the disappearance of deflation concerns is expected to encourage the Bank of England to nudge rates higher by the end of next year.

We believe that the ECB should cut interest rates but are leaning towards the view that it will not do so as upcoming concerns about a depreciating currency and current worries about fiscal laxity steady the hand of the Central Bank. However, a lack of domestic demand momentum through next year will prevent the Bank from moving policy to a tighter setting despite the improving global outlook. As a result we find ourselves in the variable camp in the fixed v floating debate with long European rates already over-pricing medium-term rate hikes.

Eugene Kiernan, head of asset allocation, Irish Life Investment Managers
We do not rule out another cut in ECB rates before the end of this year though the currency is likely to play a big role in that decision. Currently both growth and core inflation are low enough to give Trichet the leeway.

Our key view on policy rates around the world is that they will stay lower for longer than many expect. This goes against what the interest rate futures markets are saying, but they have had, in the past, a very poor record of forecasting actual interest rate moves. Central banks have put too much effort (in the case of the US) and suffered too much anguish (in the case of the ECB) to allow economies slip back. As growth does take firmer hold in 2004 we may see an up-tick towards the second half of the year but low core inflation rates around the world cap the upside.
The US Federal Reserve will continue to be the most dynamic of the Central Banks and as they were the most proactive in bringing rates down they will also be in the vanguard on the way up.

Dan McLaughlin, chief economist, Bank of Ireland
Market expectations have recently undergone a sea change, with the consensus swinging away from the idea of further rate cuts towards the notion that the next move in official rates will be up.
The initial catalyst for the change in sentiment was the perception that the US Federal Reserve is not as concerned about the risks of deflation as the market had thought, and since then the economic data in America has generally been on the firm side over the summer months. Economic growth, for example, rose at an annualised 3.1 per cent rate in the second quarter and many expect a figure in excess of 4 per cent in the third quarter, driven by a recovery in business spending

The recent tax cut package is also supporting the consumer although stubbornly high oil prices are one break on spending. The Fed has said that it will keep rates low for ‘a considerable period’ but if the unemployment rate begins to decline in the next few months, the first move in the tightening cycle may well occur by the Spring of 2004.

In the euro area the ECB may be disappointed by the trend in inflation in the early months of 2004, in part due to a weaker euro and a pick up in growth, so the repo rate in the euro area may also rise in the first quarter of next year. The exception could be the UK, where the strength of the housing market makes a rate rise this year a strong possibility.

Alan McQuaid, chief economist, Bloxham Stockbrokers
The US Federal Reserve has made it quite clear that it intends to keep the Fed funds rate low until the US is into a sustainable economic recovery and inflationary pressures are on the up-trend. There is no doubt that recent economic data point to underlying strength in the American economy, suggesting that the next rate move will be upwards, but not until the second half of next year at the earliest. Even allowing for stubbornly high oil prices, there is very little overall upward inflationary pressure at this juncture. I would agree with the consensus view that the Fed will tighten rates by 50 basis points in 2004.

As regards the UK, a lot will depend on the UK housing market, the British consumer, and probably most important of all, the performance of sterling. The jury is still out on the UK, and though another rate cut in the current cycle cannot be ruled out, I think the next move will be upwards, probably in the first half of next year. Overall, I think the level of monetary tightening next year will be between 50 and 100 basis points.

All in all, I think the underlying economic trend in the Eurozone is still weak enough to warrant a further rate cut from the ECB before the year is out, especially if the euro continues to strengthen against the dollar and/or inflationary pressures continue to ease. As regards 2004, it is highly unlikely that the Euroland economy will be growing that strongly in the first half of the year to justify a rate hike, though after that it is anybody’s guess. Although no change in rates over the full year is a reasonable assumption, given the ECB’s track record there must be some risk of 25-50 basis points of tightening in the latter part of the year, especially if the economy has started to improve.

Dermot O’Brien, chief economist, NCB Stockbrokers
The signs of economic recoveryy are growing and, for the most part, the trough in the current interest rate cycle has been reached. The Federal Reserve is clearly anxious to copperfasten the recovery and, with no fears on inflation, has declared itself prepared to leave rates low for a considerable period.

This is not the same, however, as promising to leave interest rates unchanged and our bet is that as the economic signals strengthen - particularly when employment growth kicks in over the coming months - the Fed will begin to move rates back towards less stimulatory levels. This could begin as early as Q1 2004 but, in any event, should not be delayed beyond the middle of the year. The Fed believes the long-term equilibrium level of real interest rates is about 3 per cent, i.e. a nominal level in the 4 per cent to 5 per cent range. This is, eventually where the Fed’s target rate can be expected to go but, in its current mood, we see little chance the Fed will want to get all the way there by end-2004. Nonetheless, we believe that once tightening starts it will be a continuous process and rates will be 150 basis points above current levels by the end of next year.

In Europe, hard evidence of economic recovery is still lacking but business sentiment has improved and recovery in the US will eventually drag Europe with it. Prospects for another cut depend mainly on the outlook for inflation. The ECB defines price stability as an inflation rate ‘under but close to 2 per cent’. The prospects, however, are that Eurozone inflation will fall appreciably below that target level in the early months of next year. Caught between some signs of better economic activity and this inflation outlook, we think the ECB will cut a modest 25 basis points late this year when the new ECB president, Trichet, takes office. Thereafter, as recovery gains ground, the ECB too will begin tightening again.

The UK economy has come through the recent episode in better shape than most. As a result, official rates have not been cut as much as elsewhere. Domestic demand remains strong so, as the external environment improves, overall growth will reaccelerate. Recently, the Bank of England hinted that the next move in rates will be up. We think that will come in the early months of 2004.
With official interest rates at or very close to their lows, borrowers interested in certainty should seriously consider fixing.

Donal O’Mahony, global bond strategist, Davy Stockbrokers
That the IMF is reportedly lowering (however modestly) its global growth forecasts for both this year and next compared with its Spring 2003 estimates is a tad ironic, given the rampant interest-rate pessimism that has evolved during the Summer months. The Treasury bond market is a case in point, its recent yield back-up being 10 per cent greater (in proportionate terms) than the historic bear-market average, and this achieved in 10 per cent of the average time!

The inference here is that recent bearish interest-rate sentiment has been engineered less by any dramatic change in global growth expectations, but more by the acute fall-out which has evolved from the Federal Reserve’s mismanagement of bond-market expectations regarding the chosen path of monetary policy.

In a word, the Fed are displaying a lack of seamanship in the current uncharted waters of ‘unwelcome’ disinflation, and it is their prevarication regarding the use of unconventional (Plan B) weaponry that has triggered a dramatic yield overshoot. The end-result is a credibility vacuum for Greenspan & company, their latest market exhortations regarding an output gap-induced commitment to policy stability ‘for a considerable period’ now patently falling on deaf ears as market participants revert to the ‘stronger growth = raised inflation risk = higher rates’ knee-jerk that has peppered the secular disinflationary journey of the past 20 years.

The good news is that the Fed mean precisely what it says, with more than a sufficiency of downside risks to both growth and inflation over the next 18 months to stay their tightening hand. Seeing will be believing for a currently soured and agnostic investor base, the result being an unwinding of the embedded 2004 tightening fears that permeate both US and European money-market strips. In consequence, a combination of osmosis and gravity will pull longer-term bond yields lower, thereby flattening global yield curves from their current historically elevated readings.

This prognosis warrants continued preference for floating rather than fixed-rate borrowings, given the medium-term stability of the central banks’ policy footings and the current exaggerated premium in longer-dated bond yields.

Jim Power, chief economist, Friends First
Since the last ‘Long-View’ in May, the ECB cut its official interest rates by 0.5 per cent, and the Bank of England and the Federal Reserve cut their rates by 0.25 per cent. In the case of the US and UK, this almost definitely represents the end of the easing cycle, and while there is still some scope for lower rates in the Euro area, the balance of probability suggests that the ECB will not cut rates any further.

Over the past three months we have seen compelling evidence of recovery in the US economy, while the UK continues to be reasonably robust, but even in the Euro area there are mildly encouraging signs of stronger economic activity. Against this background, it is unlikely that any of the three monetary authorities will consider further easing necessary.

However, thoughts of tightening are not on the immediate horizon in any of the jurisdictions. There is still considerable spare capacity in the US and Europe, and the risks to recovery everywhere cannot be totally disregarded just yet. The inflation prognosis remains very good so global monetary authorities will remain relaxed for a while yet. However, in 2004 the various authorities are likely to start tightening policy, with the Federal Reserve set to be most aggressive.

The trend towards higher long-term rates is likely to continue over the coming months as economic recovery everywhere becomes more embedded. Over the forecast time period long-term rates could rise by up to 150 basis pointss from current levels. Early June this year represented the cycle low for longer-term rates and the cyclical upturn has now almost reached its half way point.
So for borrowers, the current level of long-term rates is still relatively low and fixing still represents a reasonable option, but obviously not as straight forward an option as in June. However, if the global economy continues to recover at the current pace, spare capacity will be used up within a year and inflation expectations will rise and long-term interest rates will trend up from current levels.

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