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European Central Bank showing signs of upward move
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Recent figures for consumer price indices put monetary authorities on alert.
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Recent increases in consumer price indices, which reflect the rise in oil in recent months, have put the monetary authorities on the alert. While for the moment the rise in prices of oil products has not shifted to the more stable core of inflation, so-called underlying inflation, it has set off alarm bells. Nevertheless, the reply from the central banks has been qualified by the varying economic situations in each region. In the United States, the Federal Reserve will likely take a firmer stand in monetary policy than the market was anticipating. In Europe, the European Central Bank (ECB) has begun to prepare the market for an upward move which could still be postponed for some months. At the same time, the central bank of Japan has given off increasing signs of the end of interest rates at 0% although not immediately.
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In the United States, in the first weeks of October, a number of statements were made by chairmen of banks within the Federal Reserve Board, including those from Dallas, Philadelphia and St. Louis, indicating an upward trend. Publication of the minutes of the latest meeting of the Federal Open Market Committee on September 20 confirmed the Federal Reserve Board’s concern about inflationary pressures.
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US monetary markets anticipating official interest rate to stand at around 4.5% in 2006.
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In this context, the market increased its expectations of interest rate increases. While up until then discussion was centred on where the «neutral» interest rate (the rate in keeping with a path of maximum economic growth without inflationary pressures) would stand, people began to speculate that the Federal Reserve would possibly put the official interest rate higher than the neutral level in order to counteract inflation. In fact, the head of the Federal Reserve Bank of San Francisco, Janet Yellen, considered that the neutral interest rate stood in the range of 3.5%-5.5%. As a result, the interest rate on 1-year interbank deposits showed a substantial increase in the early weeks of October going above 4.5%. Money market operators are thus already anticipating that the Fed’s reference rate will stand at around this level in 2006.
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It is very likely that the Fed will raise interest rates on November 1 and December 13, the dates set for the two other meetings this year so that the objective interest rate level for Federal Funds, overnight interbank deposits, could stand at 4.25% at the end of 2005. The subsequent meeting of the Federal Reserve would take place on January 31, the date on which the current chairman, Alan Greenspan, steps down. President George W. Bush has named Ben Bernanke, who holds the post of Director of the President’s Economic Policy Advisory Board and previously had been on the Federal Reserve Board, as his successor. Given that the new chairman of the Federal Reserve will probably wish to confirm his anti-inflationary credibility, it would be reasonable to think that the Federal Reserve will raise its interest rate at least to 4.5% in the early months of next year.
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European Central Bank beginning to prepare market for increase in Eurosystem rate.
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In the euro area, the Governing Council of the European Central Bank decided to maintain the main interest rate of the Eurosystem at 2%, unchanged since June 2003. Nevertheless, ECB chairman Jean-Claude Trichet hardened his rhetoric stating that, while interest rates stood at the correct level, risks of inflation were clearly on the rise. At the same time, he expressed concern about the expansionist path being taken by money supply figures and credit to the private sector. In fact, the annual growth rate of the broad M3 money supply figure stood at 8.1% in August, far from the reference growth rate of 4.5%. In turn, the year-to-year increase in loans to the private sector was 8.4%.
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Main ECB concern is that rise in inflationary pressures could spread to core inflation.
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The ECB’s main concern is that the increase in the general CPI for the euro area, which reached 2.6% at year-to-year growth rate in September, could shift to core inflation. This rose by 2 decimals in September but still stands at the low level of 1.5%. In this context, the 12-month Euribor, which held at 2.22% on average in September, by the early weeks of October had risen to above 2.4%. In this way, the market has moved forward the point at which it expects to see the restrictive turn in the ECB’s monetary policy, placing that moment at the beginning of 2006. In fact, the ECB will probably not raise its interest rates until there is confirmation of recovery of the economy in the euro area and there are no «second-round» effects, that is to say, increases in wages and prices.
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The Bank of England also held its intervention rate at 4.5% at the meeting of its Monetary Policy Committee at the beginning of October. Although there later was speculation that a new downward move was imminent, publication of the minutes of the previous meeting which showed the unanimity of committe members on the decision adopted, somewhat cooled prospects of a further easing of monetary policy. Furthermore, inflationary pressures are increasing.
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In addition, in the second week of October, the Bank of South Korea announced that it was raising its official interest rate for the first time in more than three years, putting it up by 25 basis points to 3.5%, in order to deal with inflationary pressures. This measure came about in a framework of economic recovery in this Far-East country. On October 18, the Bank of Canada also again increased its reference rate and put the overnight rate at 3.00%.
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Investor demand for US bonds continues to support dollar
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Central banks of South Korea and Canada raise interest rates in October.
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The dollar rose by 3.0% in the January-September period compared with a broad basket of currencies. This appreciation was especially brought about by the favourable differential in interest rates against the euro and the yen and by relatively high economic growth. Foreign investors continued to buy US securities, especially bonds, in sufficient quantity to fund the foreign imbalance. As a result, the US currency was able to counter downward pressure coming from the huge foreign deficit of the US economy.
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Increased interest rate differentials favouring dollar strengthen that currency.
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In the early weeks of October the greenback appreciated with the increasing prospect of official interest rate rises by the Federal Reserve with a subsequent widening of interest rate differentials. At the same time, repatriation of profits under a law which provides tax advantages if they take place before the end of this year also went in its favour. Furthermore, publication in mid-October of a trade deficit in August that was lower than expected also aided the dollar. In any case, the dollar will probably drop over the mid-term, especially against the Asian currencies.
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Euro reaches point of downward resistance at around 1.19 dollars.
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The euro dropped by 6.3% in the first nine months of the year compared with the group of currencies of its main trading partners following a substantial rise in the last quarter of 2004. The modest economic growth of the euro area, the increase in differential in interest rates, which went against it with regard to other currencies, and the «No» vote on the European constitution in referendums held in France and the Netherlands in May and June setting off a political crisis, hurt the European single currency. In the early weeks of October, the euro held its positions with the prospect of an upward turn in interest rates by the European Central Bank and with the contribution of buying by Asian central banks wanting to diversify their foreign currency reserves. In relation to the dollar, the European currency showed some swings finding its point of downward resistance at around the level of 1.19 dollars.
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Yen depreciates substantially so far this year but will likely rise because of economic improvement.
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The yen dropped by 5.2% in the first three months of the year in terms of a group of main currencies, having been hurt by an unfavourable differential in interest rates compared with other currencies, due to an official rate close to 0%. In the early weeks of October, the Japanese currency tended to depreciate in spite of the improvement in economic prospects. This trend may be explained by the outflow of capital in search of higher yields abroad. As a result, in the third week of the month, the yen marked up its lowest level against the dollar since September 2003. Nevertheless, the yen showed a rise against the euro since December. In the future, the Japanese currency likely will rise as a result of the improvement in the economy.
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End to downward trend in bond yields
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Yield on US Treasury bonds moves up with growing prospects of interest rate increases by Fed.
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The yield on US 10-year Treasury bonds has tended to rise since the beginning of September as a result of the increase in prospects of higher Federal Reserve interest rates. As a result, in the fourth week of Ocober, the yield stood close to 4.5% returning to the level seen in March.
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The yield on German 10-year government bonds rose in the fourth week in September after having marked up 3.02%, the lowest level in recent decades. This increase was brought about by growing concern about the trend in inflation and the expected bringing forward of the date of an increase in the ECB offical interest rate. As a result, the interest rate on German long-term government bonds stood at around 3.3% in the third week in October. On the other hand, the differential with similar US bonds has continued to widen in recent weeks going to 120 basis points.
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Widespread corrections in stock markets in October
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Various European, Asian and emerging markets mark up highs for recent years at beginning of October.
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As a result of better than expected corporate profits and low interest rates, a number of stock markets in Europe, Asia and emerging markets reached their highest levels in recent years at the beginning of October in spite of high oil prices. They thus showed revaluations better than forecast at the beginning of the year. Nevertheless, increasing concern about inflation and the rise in long-term interest rates ended up bringing about a widespread correction in the stock markets.
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Main US indices stand below par for year…
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In this context, stock markets in the United States showed a worse performance. Following gains obtained in 2004, US shares showed some overvaluation in terms of other markets. Another differential factor was the successive increases in the Federal Reserve interest reference rate during the year which have hurt the markets. As a result, in the fourth week of October, the main US stock market indices stood below par for the year.
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By sector, largely as a result of revaluations of oil company shares because of increased oil prices, the energy sector and public utility companies showed major capital gains over December. On the other hand, telecommunications companies and those in cyclical consumer goods and materials have reported capital losses so far this year.
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…while European markets record substantial cumulative gains over December…
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On October 4, the DJ Eurostoxx 50 which includes the largest companies in the euro area, marked up its highest level since May 2002 to show a cumulative capital gain of 17.4%. The drop in the euro during the year, maintenance of interest rates by the European Central Bank at very low levels and major profit increases by European companies pushed up stock markets on the Continent. In spite of corrections in October, most of the main markets in the euro area showed considerable capital gains in the fourth of the month, headed by the markets in Madrid and Paris.
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With regard to the Spanish stock market, the IBEX 35 index reported its highest level for the past five years on October 4, thanks to favourable corporate profits. Later on, it dropped somewhat but, in any case, in the fourth week of October this index was showing increases of 15% over December. It should be pointed out that in the final week of the month, only 7 of the 35 shares in the selective index stood below the level at the beginning of the year.
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…along with Japanese stock market.
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Outside the euro area, the Financial Times 100 index for the London stock exchange recorded its highest level since August 2001 at the beginning of October. The SMI index for the Swiss stock exchange showed a rise of more than 21% over December, in spite of the corrections taking place in October. On the other hand, on October 4, the Nikkei 225 index for the Japanese stock exchange marked up its highest level since May 2001 driven up by the improvement in economic prospects. Following later decreases, it was still showing cumulative revaluations of two digits.
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Some emerging markets, such as India, South Korea, Brazil and Argentina record all-time highs at beginning of October but later drop back.
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With regard to emerging markets, some of these, such as India, South Korea, Brazil and Argentina, showed all-time highs at the beginning of October thus reflecting their present good economic situation and the flow of international capital going into those markets. As a result, many emerging stock markets showed major capital gains in the first ten months of the year.
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