Where now for global interest rates?

Quentin Fitzsimmons, Threadneedle Head of Government Bonds, offers an insight into the issues and challenges currently facing the world’s central banks.

The US:

The US economy is at an interesting juncture. Corporate earnings have been growing at a rapid pace and consumer confidence remains high, but we continue to keep a close eye on the slowdown in the housing market. We are particularly concerned about the deteriorating outlook for the sub-prime mortgage sector and note that some lenders have become insolvent over the past few months.

We are heartened that inflation has moderated on the back of weaker energy prices and since the pace of corporate earnings growth is likely to decelerate, we believe interest rates are more likely to fall than rise in the remainder of the year. Against this background, we believe US treasuries offer reasonable value at current levels.

The UK:

The market was surprised by the MPC’s decision to raise interest rates in January and investors are nervous about further monetary tightening. The Bank of England’s latest inflation report, however, leads us to believe that the hike does not represent the beginning of a new phase of tightening.

It remains likely that rates will be raised to 5.5%, although this will be dependent on wage settlements. However, currently wage settlements do not appear to be running at a significantly faster pace than last year. Meanwhile, inflation has started to fall and it is possible that headline inflation will fall below the government’s 2% target by the end of the year as the impact of higher energy prices begins to fade. Price cuts from utility companies, such as British Gas, will exert welcome downward pressure on inflation.

We believe that 2-year gilts offer good value with yields at 5.5%. This level was achieved earlier in the month and, while yields have since fallen, we remain positive on the outlook for gilts.

Europe:

The European economy ended 2006 on a high note. Even the region’s laggards, such as Italy, have recently posted improved growth numbers. Against this background, the ECB is likely to continue to raise the cost of borrowing, with interest rates likely to hit 4% by year-end. Inflationary pressures are likely to remain modest.

10-year European government bonds yields seem to have found support around the 4.0% level and should attract buyers in due course as investors become confident that a peak in eurozone interest rates is in sight.

Japan:

The Bank of Japan raised interest rates by 0.25% to 0.5% today. While economic data has not been particularly strong, the yen has been weak and Japan is coming under increasing pressure from western trading partners to address this. However, the fact that the economy is still in a state of modest deflation suggests to us that interest rates will not be raised beyond 0.75% this year.

Conclusion:

We are most positive on the prospects for US treasuries, followed by UK gilts. Japanese government bonds are less attractive, although foreign investors might benefit from currency appreciation. European government bonds are reasonably attractive, but we suspect there might be a little more uncertainty to pass through before we will be buyers.