Global Markets Weekly – 18^th June 2007

Key global market developments

• Equity markets advanced again last week, reversing the previous week’s losses, which had been driven by a sharp rise in global bond yields. The gains came in the second half of the week, as US ten-year yields fell back a little from Wednesday’s intra-day high of 5.3%. Our analysis shows that the volatility in equities has been caused not by the new level of bond yields but by the speed of their rise, up from 4.6% just a few weeks ago. Sharp moves in bond yields have a coincident impact on equity markets; they don’t predict equities’ future direction. Bond yields have not reached the level where they turn negative for equities, and we still favour equities over bonds.
• The steep rise in bond yields has been driven by a combination of cyclical and structural forces. The most obvious is the exceptional strength of global growth: the upturn is showing few signs of moderating, and spare capacity is limited. Hence, inflation expectations could well come under intermittent upward pressure.
• But cyclical forces may have limited scope to drive yields higher, as a significant degree of further monetary tightening is already factored into expectations across many economies. And we mustn’t forget the impact higher bond yields will have on economic activity. How, for instance, will the fragile US housing market cope with a sudden rise in mortgage interest rates for new borrowers? That should help to limit how far yields rise.
• The more intriguing element is the potential for structural or geo-political factors to destabilise bond markets, creating uncertainty and a possible overshooting of yields in the process.
• The conundrum of unusually low long-term interest rates has attracted no end of commentary in recent years. The key question occupying investors now is whether this effect has begun to unwind. Several factors are believed to have contributed to the earlier reduction in long-term rates. Pension funds have been buying long-term bonds in order to match the duration of their liabilities, and the more stable macro-economic environment has reduced the premium investors demand for holding longer-term assets. Although the inflationary outlook may now be less certain than for several years, such forces are unlikely to reverse in the near term.
• Yet the bigger question is over the actions of central banks in Asia (notably China) and the Middle East. They have been big buyers of US Treasuries, in order to reinvest the huge foreign exchange (FX) reserves generated by their managed exchange rate regimes. Such purchases may have lowered the 10-year US Treasury yield by as much as 100-150 basis points, suggesting that substantial upside for yields remains if demand from central banks wanes. That could happen in the event of greater exchange rate flexibility in Asia, which would reduce the growth of FX reserves, or if the flow of FX reserves is directed towards a broader range of assets. Hence, the growing calls from the US Congress for a faster appreciation of the Chinese yuan are of direct relevance to global bond markets. While the US Treasury Department last week stopped short of naming China as a currency manipulator, the pressure for exchange rate reform remains. Protectionism could also be a key market driver ahead of the US Presidential elections next autumn. So the possible unwinding of the low-interest-rate conundrum is likely to remain the focus of attention for some time.
• The implications for other assets are broad, given that the theoretical price for all other assets is based on the ‘risk free’ return from developed market sovereign bonds. Yet the impact would vary, depending on whether they are still ‘cheap’, like equities, and so remain attractive, or ‘expensive’, like UK property, and have to battle a growing headwind. Within commodities, it would put gold under pressure, as higher yields increase the opportunity cost of holding an asset with no yield. But industrial metals and oil would see a net benefit from the robust global economic growth and rising prices for natural resources that have driven the shift in yields.

Indices, Interest rates and Inflation

	Close 15-Jun-07	1 Week%	1 Month%	3 Months%	YTD %
FTSE all share	3478.99	3.40	1.91	9.16	8.00
FTSE 100	6732.40	4.49	2.49	9.77	8.22
S&P 500	1532.91	1.67	2.11	10.10	8.08
Nasdaq Composite	2626.71	2.07	4.02	10.43	8.75
DJ Stoxx (Europe)	440.89	3.90	2.45	13.09	11.44
Nikkei 225	17971.49	1.08	2.62	6.59	4.33
Hang Seng	21017.05	2.48	0.71	10.79	5.27

Official Rates (%)				Inflation (%)	Rate announcement
	Current	Dec-07 Forecast	Jun-07  Forecast	Current	Next Date
US (Fed Funds)	5.25	5.25	5.00	2.7	28-Jun
UK (Base rate)	5.50	5.75	5.75	2.5	05-Jul
Euro-zone (Repo Rate)	4.00	4.50	4.50	1.9	05-Jul
Japan (Call rate)	0.50	0.75	1.25	0.0	12-Jul

	Selected Global Indicators	Consensus Forecast	Previous Result		Date	Time
US	NAHB Index (Jun)	29	30	month	18-Jun	18:00
GE	ZEW Survey (Jun)	29.0	24.0	month	19-Jun	10:00
US	Housing Starts (May)	1480k	1528k	saar	19-Jun	13:30
US	Building Permits (May)	1470k	1457k	saar	19-Jun	13:30
JP	BoJ MPM minutes (Apr 27th meeting)				20-Jun	06:00
UK	M4 Money Supply (May)	13.4%	13.3%	yoy	20-Jun	09:30
UK	MPC minutes (June 6th meeting)				20-Jun	09:30
UK	CBI Industrial Trends (Jun)			quarter	21-Jun	11:00
US	Philly Fed Survey (Jun)	6.0	4.2	month	21-Jun	17:00
FR	Household Spending (May)	2.6%	2.5%	yoy	22-Jun	07:45
GE	IFO survey (Jun)	108.4	108.6	month	22-Jun	09:00

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