Cycle of Worldwide Interest Rate Hikes Remains Measured

Fed to raise interest rates to 5.5% by the end of 2006, EZB to 3.50% and BoJ to 0.50%
Environment will become less friendly for markets

The policy of the central banks is currently the main factor driving the markets. The main reason for this is fears that the central banks could carry interest rate hikes to excess. However, as the risk of sustained, sharp rises in inflation is low, (not least of all because of the impact of globalisation) the central banks will continue to act moderately and unaggressively. “Although the environment for the markets will be less friendly next year due to the expected slowdown in economic growth and lower liquidity, there should be no pronounced selling pressure,” said Gerhard Winzer, head of Fixed Income Research Major Markets at CA IB.

The ECB left the key interest rate unchanged at 2.75% on 6 July, but sent strong signals that interest rates could be raised on 3 August. The ECB expects economic growth to continue at around potential (2006: 2.1%, 2007: 1.8%). It announced that if its baseline scenario were confirmed it would continue its progressive withdrawal of monetary accommodation. Indeed the ECB even judges that the medium and long-term inflation risk which for months has been on the upside has increased. The reason: the dynamic growth of money and credit combined with already ample liquidity. However, the rate of inflation should remain only slightly above the medium-term ECB target both in the current year (2.3%) and the next (2.2%). Thus the ECB will continue to bring the key interest rate toward a neutral level (year-end 2006: 3.25% to 3.50%). However, there are no compelling arguments for a restrictive interest rate level.

On 29 June the Federal Open Market Committee raised the key interest rate to 5.25%. It sees a weakening of the economy which will reduce inflationary pressure in the medium term, but judges that some inflation risks remain. The FOMC did not specify either the extent or timing of any additional interest rate rises. However, the economic slowdown could come too late to induce an interruption to or end of the cycle of interest rate hikes as early as 8 August. The interest and currency analysts of CA IB expect an increase of 25 basis points. “After 8 August, there should be no more tightening of interest rates," said Winzer. Firstly, there will be a sustained downturn in economic activity (2006: 3.4%, 2007: 2.7%). Secondly, the current acceleration of inflation rates is probably only of a temporary nature (2006: 3.5%, 2007: 2.8%).

Upbeat Mood in Japan
In Japan economic indicators point to a sustained economic recovery (2006: 2.7%, 2007: 2.1%). The positive business mood, inadequate employment levels at companies and the shift away from deflation are noteworthy. Economic and inflationary trends therefore militate in favour of a shift away from the policy of zero interest rates, possibly as early as this Friday. However, both the extent and frequency of the interest rate rises will turn out moderately (25 bp per quarter), as inflation will accelerate only slowly (2006: 0.4%, 2007: 0.8%).

If the central banks are ranked on a “hawkometer” (according to their inflation anxieties), the ECB ranks ahead of the FOMC and the Bank of Japan. This explains the most recent firming of the euro against the US dollar and the yen. It is generally considered that the US dollar will only significantly weaken against the euro and the yen when a (definitive) end to the Fed cycle of interest rate hikes is in sight. (Year-end 2006: EUR vs. USD 1.30, USD vs. JPY 105). The yen will only have clear potential for firming up against the euro at the end of the ECB interest rate cycle (2007).

On the financing side, interest rate hedges on the short end remain attractive. For foreign currency financing the Swiss franc should be given clear preference over the yen. The anticipated continued loss of appetite for risk on the part of investors will lead to a reduction of the investment risk in markets with negative fundamental data (e.g. US dollar, New Zealand dollar, Iceland crona) and an overweighting of markets in which GDP growth has become self-sustaining (e.g. euro, yen).

Enquiries: Bank Austria Creditanstalt  International Markets
Veronika Fischer-Rief, Tel.: 050505 Ext. 82833;
E-mail: veronika.fischer-rief@ba-ca.com