Interest rates back to fixate investors

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  • Posted on April 15, 2011

    By Jeremy Gaunt, European Investment Correspondent

    LONDON (Reuters) – Financial markets have swung back into a new but familiar phase — worrying about interest rates — and, not coincidently, the euro zone debt crisis is also bubbling after a brief hiatus.

    It all points to a couple of weeks ahead that are likely to be volatile — risk-on, risk-off — with a particular focus on the U.S. Federal Reserve’s meeting on April 26.

    The interest rate issue is at its most obvious on the foreign exchange market, where carry trading has returned. Investors are borrowing in low-yielding currencies to invest in higher-yielding ones.

    The euro, for example, is at its highest in 15 months against the dollar.

    This is being driven by yield differentials now available after the European Central Bank raised interest rates (with more likely to come) while Japan keeps monetary conditions ultra-loose following its devastating earthquake and tsunami.

    A sort of middle ground is being held by the Fed, which is not likely to raise rates until next year, but which has to decide on the future of its asset-buying quantative easing (QE) program, due to end in June.

    It is at this point that equity investors come into the picture. QE has produced a flood of liquidity into markets that has essentially driven investors into stocks, in part because it has made a lot of fixed income unattractive.

    Equity markets have been remarkably resilient, shrugging off just about everything that is being thrown at them, from rocketing oil prices, wobbly euro zone debt, a big blow to Japan’s economy, and a revolt in the Arab world.

    Gary Baker, head of European equity strategy for Bank of America-Merrill Lynch, says equity investors are actually “reluctant bulls” who can’t fight Fed-driven liquidity.

    “They see very little alternative to equities,” he said.

    It all makes markets highly vulnerable to sudden, surprising change. So any comments from the various factions in the U.S. central bank hierarchy over the next few weeks may be even more market-moving than usual.

    Flash PMIs from across the euro zone may also be signposts to the ECB’s next move.


    Interest rate speculation is also playing into the euro zone debt crisis, with the tighter ECB policy and strong euro doing few favors for the struggling peripheral economies.

    This is most evident in Greece, where the spread between 10-year bonds and German equivalents is now more than 1,000 basis points and talk is rife of restructuring being needed.


    By Jeremy Gaunt, European Investment Correspondent

    Prime Minister George Papandreou said on Friday that Greece would present details of fresh austerity and privatization plans after Easter. They are an attempt to convince markets it can tidy up its finances and avoid restructuring.

    Investors, however, continue to pressure peripheral debt, despite various plans to draw a line under the problem. Papandreou’s announcement that details would come later did little to ease concerns.

    Differing interest rate prospects, in the meantime, have been a major catalyst behind the recent shift of investment flows into emerging markets.

    Fears of tightening in red-hot emerging economies put some investors off at the beginning of the year, but a belief that the rate cycle was peaking opened the door to aggressive new flows.

    Again, this makes markets particularly vulnerable to surprises, epitomized by the risk-averse reaction to China’s increasing growth and higher consumer price inflation reported in the past week.

    India also reported higher than expected inflation.

    The coming week brings central bank meetings in a number of major emerging markets, notably Hungary, Brazil, Turkey, Israel and Thailand.

    Turkey may be the most interesting as it will feature a newly appointed central bank governor, Erdem Basci, widely seen as the main architect of the country’s unorthodox monetary policy, which twins rate cuts with rises in bank reserve ratios in order to tighten policy.


    The remarkable performance of world equities, meanwhile, will be tested in the coming week by the latest earnings season, this time with Europe joining in with Wall Street.

    The U.S. reports will be dominated by banks, including Goldman Sachs, Citigroup and Wells Fargo. Europe will hear from the likes of Novartis, LVMH and Peugeot.

    Europe may disappoint. Thomson Reuters StarMine data suggests STOXX Europe 600

    Sentiment on the equity market nonetheless remains constructive as seen in commodity trader Glencore’s planned $12 billion initial public offering next month.

    (Additional reporting by Sujata Rao and Dominic Lau; Editing by Catherine Evans)

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