Further interest hikes due in second half of year
- Bond yields by contrast to post modest increases
- Volatility of exchange rates remains historically low
- Interest could be pushed up to 4.5%
A balanced macro environment coupled with continued low volatility in growth and inflation figures has enabled central banks to continue their steady process of normalisation. "In the euro area, the anticipated increase in the key rate of 25 basis points to 4% this coming Thursday is by no means the last interest movement this year", explained Michael Rottmann, Head of Global Fixed Income and Foreign Exchange Research at UniCredit Group.
The comments from ECB members suggest that a neutral level of interest for them is between 3.5% and 4.5%. Based on the above-average economic development, Rottmann believes that the ECB will make full use of this and raise the key rate in two further steps up to 4.5%.
The monetary policy situation in the USA is certainly set to undergo wide-scale changes. In the last few weeks for example the interest cut expectations have more or less been priced out in full. If our outlook of a perfect "soft landing" proves to be correct, the talk in the second half of the year will switch to interest rate hikes in 2008. UniCredit analysts reckon that the interest rate hike cycle in Japan will be continued, adding 25 basis points every six months.
Sound inflation environment
Inflation is still not an issue. It is not just in the last six months that inflation in the euro area has hovered around 1.8% and 1.9% in line with the ECB's target. Going forward, inflation should settle at around 1.9% in 2007 and at 2.0% in 2008. Core inflation in both years is likely to amount to 1.9% as well, while in the USA, the volatility of the core rate of inflation is projected to remain low in both of the coming years and total 2.5%. Although inflation is slightly above the imaginary target band for inflation set by the US Federal Reserve of 1-2%, this does not give cause for concern.
Bond yields rising modestly
In spite of the upward trend in interest rates, yields on long-dated bonds are only set to post marginal increases. Interest hike expectations have to a large extent already been priced into money market forwards. Consequently, monetary policy tightening will not cause any surprises. No major volatility is anticipated in growth or inflation either. Thus a higher risk premium for long-term government bonds is not necessary.
Since the beginning of the year, 10-year Austrian government bonds have moved up from just under 4% to 4.50%. Therefore the most painful stage of the trend may already be behind us. Any further potential in terms of rising yields will be no more than 25 basis points in our view.
Volatility still low in exchange rates
Under these conditions, exchange rates should remain between clear bands. Interest hike expectations in the euro area in respect of the EUR-USD rate are already broadly priced in and are not likely to lend the EUR any additional support.
In the USA, by contrast, the swing from interest cut expectations to interest hike expectations should bolster the USD. Even though the peak so far of 1.3680 may be passed temporarily, in light of the perfect "soft landing" in the USA the medium-term trend is likely to point towards 1.30. The JPY and CHF, traditional currencies for debt financing, are not likely to stabilise suddenly as long as there is no unified political commitment. And this consensus is still not forthcoming, as demonstrated by the last meeting of G7/G8 countries. Only once there is a clear statement of intent will it be time to say goodbye to debt-financed positions. Until then, the exchange rates will remain driven purely by relative money market expectations.
Investing in the money market is most appealing for investors during the ongoing interest hike cycle. The flatness of the interest curve means that the return in comparison to long-term bonds is not all that much lower. On the other hand, further – albeit modest – yield increases do not lead to temporary losses.
The CZK is suitable for financing in foreign currencies, especially since the Swiss franc has weakened significantly in recent months. In light of the considerable risk of a decline we would avoid debt financing in the JPY.
Contact: Veronika Fischer-Rief
UniCredit Markets & Investment Banking, PR Office
Tel. +43 50505-82833,
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