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To: Crimson Ghost who wrote (42638)	10/11/1999 5:46:00 AM
From: Alex	Read Replies (1) \| Respond to of 116767

Interest Rates Will Go Up Central banks getting their ducks in a row. The markets had a lucky escape last week when all three big western central banks kept interest rates on hold. But the relief may prove temporary. The US Federal Reserve, which has tightened monetary policy twice since the end of June, is likely to do so once again on November 16. The Bank of England may even beat the Americans to the punch. And the European Central Bank is soon expected to raise rates for the first time. With the notable exception of Japan, rates are rising across the industrialised world. It is easy to see why central bankers are suddenly on guard. Recovery from last autumn's crisis has been remarkably swift and comprehensive. The US shows few signs of slowing down. Third-quarter gross domestic product is likely to expand by 4-5 per cent despite a considerable drag from the current account deficit. Last week's 5.1 per cent surge in German manufacturing orders shows recovery taking hold in the euro-zone. Even Japan is rising from the dead judging by the more optimistic tone in the latest Tankan business confidence survey. Put that together, and global growth is likely to surprise on the upside, according to Salomon Smith Barney. The investment bank is forecasting growth of 2.5 per cent among the industrial economies this year, rising to 2.75 per cent in 2000. But Kim Schoenhoeltz, its chief economist, thinks those estimates will end up looking conservative. Improving growth has rekindled inflationary fears. In the US, rising oil prices are pushing up the consumer and producer price indices, though their core measures remain subdued. Of more concern to Fed chairman Alan Greenspan is the tightness of the labour market, even though last Friday's September employment report - showing a small drop in the payroll numbers - provided a bit of relief. The Bank of England's monetary policy committee has also cited the labour market as well as rising house prices and growing consumer confidence to explain its rate increase last month. Even Europe is beginning to experience a gradual fall in employment, though it remains uncomfortably high. What should investors make of this mix of rising rates, higher growth and potentially rising inflation? One fairly straightforward conclusion is that it points to dollar weakness. As growth differentials narrow between the US and the rest of the world, foreign investors will tend to repatriate their money. As they sell American assets, the US will have increasing difficulty financing its current account deficit, potentially forcing it to raise interest rates higher and thus further dampening growth - a vicious circle in the making. This process has already begun; the dollar has weakened dramatically against the yen since July. But at $1.07 to the euro, it has hardly budged against the new European currency. That probably reflects the fact that international investors were chronically short of yen at the start of the year, while they have been fully weighted in Europe. Nevertheless, it suggests upside for the euro in the months to come. Higher growth and inflation is typically bad for bonds, though current yields already reflect much of that. The short end of the yield curve and futures markets are pricing in up to 150 basis points of tightening in Europe and one or two more US rate rises. The fact that the central banks appear willing to take strong, pre-emptive action should also increase investors' confidence that any uptick in inflation will be contained. This is further underpinned by the fact that real yields are already relatively high, balancing expected above-average growth. In the US, for example, they are close to 4 per cent, given expectations of 2-2.5 per cent inflation and a long bond yield of nearly 6.2 per cent. Consequently, if central banks end up not having to raise rates by as much as the markets currently expect, bonds should stage a decent rally, especially as fears of a Y2K liquidity crunch are likely to push money into safe Treasuries, gilts and bunds. Stocks, meanwhile, ought to benefit from higher growth and the stronger earnings this produces, even though rising rates will dampen this somewhat. The snag here is valuations, especially in the US where they remain very rich. As the year end approaches, bonds may turn out to be a better bet than equities. The Financial Times, October 11, 1999