Global Markets Weekly – 29^th May 2007

Key macro-economic developments

• Equity markets have grabbed most of the headlines so far in 2007, whether for the level of merger and acquisition activity or for the spectacular advances in China and elsewhere. Last week, though, developments in bond markets certainly proved worthy of attention. Yields continue to head higher in response to solid growth prospects and stubborn inflationary pressures, particularly in the United States, where the yield on the 10-year Treasury note touched 4.9%, its highest level for roughly four months.
• Although Treasury yields have risen across the spectrum of maturities as expectations of an early rate cut from the Federal Reserve have receded, the largest increases have been concentrated in longer-dated notes. Indeed, for a brief period last week, the yield on the 10-year Treasury moved above the 3-month bill rate. If sustained, this could well prove to be an important development for sentiment towards the US economy, given that the shape of the yield curve is seen as a bellwether guide to growth prospects. When the US yield curve is inverted with 10-year yields below the 3-month bill rate – as has been the case over the past few months – that has typically been seen as a harbinger of recession. Admittedly, the quality of the economic information provided by yield curve movements is believed to have declined in recent years, mainly because of disproportionate demand for longer-dated securities from Asian central banks regurgitating trade surpluses and from pension funds. Nevertheless, a reversal of this factor would certainly be welcome.
• But, if this latest rise in yields had initially been sparked by concerns over what exchange rate reform in China may mean for the demand for Treasuries, last week’s movement was driven more by fundamentals, after a string of stronger data from the US economy. The April figures for durable goods orders – which are seen as a reasonably accurate proxy for investment expenditure – recorded a second successive monthly increase, allaying concerns over a possible retrenchment of expenditure within the corporate sector after a soft start to the year. There was even some better news from the housing market, with the new home sales figures for April topping the most optimistic forecasts, even if such volumes appear to be the result of substantial price discounts.
• It now appears that US homebuilders are willing to accept lower prices in order to facilitate sales and ultimately consolidate their balance sheets, which had appeared vulnerable to a developing overhang of unsold properties. The number of new homes available for sale now equates to roughly six times the prevailing level of monthly sales – a ratio which, though some way above the average of recent years, is considered fairly normal. The housing market slowdown still seems to be some way from clearing, and existing home sales were roughly unchanged in April, but any further better news from this quarter will again support growth prospects for this year and beyond.

Key global market developments

• The rise in bond yields is rather more advanced in the UK than in the US. The two-year gilt yield rose to an almost seven-year high (of 5.7%) last week, thanks to a hawkish set of minutes from the May meeting of the Bank of England’s Monetary Policy Committee (MPC). Such a level would appear to be based on the assumption of at least one further increase in rates, but upward pressure on yields is likely to persist while the impact of the earlier monetary tightening seemingly remains muted. However, a key factor is likely to be the growing share of borrowing on fixed interest rates within the UK mortgage market, which suggests that a substantial reaction from households could yet occur, albeit with a lag. Several MPC members voiced a reluctance to push up rates aggressively as long as doubts remain over the impact of the earlier tightening, and the release this week of the April mortgage approval data may again show that signs of a slowdown in the housing market are indeed developing.

Indices, Interest rates and Inflation

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