Global Markets Weekly – 19^th February 2007

Key Macro economic developments

• There was plenty of news on the macro front last week and, for the most part, the equity markets liked what they saw. Federal Reserve Chairman Ben Bernanke - delivering his testimony to the US Senate - took centre stage, but such an event could well prove to be an infrequent occurrence in 2007, as the economic scenario outlined by Mr Bernanke suggests that the Fed could well be about to take more of a ‘back seat’ over the coming year. Growth in the US is expected to proceed at a roughly trend pace as the housing market continues to stabilise, with the Fed’s forecasts looking for a rise in GDP of between 2.5% to 3% this year and 2.75% to 3% next, while unemployment is seen as steady within a 4.5% to 4.75% range.
• Risks clearly remain, and Mr Bernanke highlighted several trends that warrant careful monitoring over the coming months. Even if the headline housing market figures appear to be showing a reasonably orderly slowdown, the recent rise in delinquencies on sub-prime mortgages is a concern, particularly as the latest survey of loan officers by the Fed pointed to some tightening of credit conditions. Inflation, and the risk that a prolonged run of elevated price pressures will lead to a pick-up in medium-term inflation expectations across the economy, remains the primary risk, but again Mr Bernanke appeared confident that price pressures had already begun to diminish.
• Overall, there was little in the testimony or the Fed’s economic report to suggest that policymakers see any need for urgent action on the monetary policy front. Indeed, Fed officials are likely to draw a fair degree of professional pride from the fact that many market participants now have no strong view of the direction of the next move in interest rates - not due to any lack of transparency on the Fed’s behalf - but because the US economy seems to be progressing in reasonably good shape.
• The Bank of England’s February Inflation Report, meanwhile, shows the Monetary Policy Committee (MPC) to still have a tightening bias, but the likely extent and timing of any rate hikes appears less certain after last week’s data releases in the UK. The inflation and labour market data suggested the threat of wage-price spiral to still be more of a possibility than a reality, while the January retail sales data revealed the largest monthly drop in sales for some four years even as deflation returned to the High Street. The more macabre interest rate forecasts also came under pressure from some further, tentative signs of a slowdown in the housing market.
• We are not surprised to see the pound on the back foot at present, particularly against the euro, where the fourth quarter GDP figures comfortably beat analyst expectations and the more forward-looking indicators of activity remain at elevated levels. Concerns over the level of spare capacity within the Euro-zone economy could soon begin to emerge, particularly as estimates of 2007 growth (for Germany especially) are still firmly on the upgrade.

Key global market developments

• The sharp increase in Japanese GDP, rising by 4.8% on an annualised basis during Q4 2006, provided arguably the most welcome news of last week, given that confidence in the Japanese recovery story had generally been on the wane in recent months. The ongoing weakness of the yen has been the most evident manifestation of this changing sentiment. But the better GDP data – coupled with the increased probability of a Bank of Japan (BoJ) rate hike on Wednesday – led the currency to enjoy a minor revival in trading last week once the initial disappointment that followed the G7 meeting passed. All of this has again raised questions over the sustainability of the yen carry trade, and some reduction of the large speculative short position against the currency could easily occur if the yen is no longer regarded as a ‘one-way bet’. However, with risk appetite remaining at a fairly robust level and the BoJ unlikely to push rates up aggressively over the coming year, it still appears to early for any major shift in market behavioural patterns to occur.

Indices, Interest rates and Inflation

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