Higher rates needn't scare investors

1997: A preview of the year ahead: CAPITAL MARKETS

This will be the year of rising interest rates. Short-term rates will rise swiftly in the UK, more slowly in the US and - by the end of 1997 - also begin to rise across continental Europe. The key test for financial markets will be to see how confidently investors can look beyond this cyclical rise and discern the longer-term downward trend. If they are frightened by the rise then it will be a bumpy year for both bonds and currencies; if they can take the long view then the sunlit uplands still beckon.

It will be interesting to view the year from Britain. That is not because what happens to UK domestic markets has much influence on the rest of the world. It doesn't. The tail does not wag the dog. Rather it is because the upturn in interest rates will happen here first. It will happen because the new government, whoever is running it, will have to lean against strong economic growth as one-off boosts (from things like the building society conversions to plc status) add to strong underlying demand.

The result will be strong pressure on the Chancellor, whoever he may be, to get interest rates up fast. The quicker he responds, the less damage there will be to long-term interest rates, but a sharp rise in short rates will inevitably make sterling more attractive. So sterling should remain strong too.

How high will short-term rates go and how much effect will this have on the pound? UK base rates will probably end the year at or close to 7 per cent. Anyone who tries to call the exact timing of the rises will be wrong, but a plausible profile will be one more quarter point rise before the election and then another three through the summer and autumn. The peak in the interest rate cycle? Probably not till well into 1998.

Impact on gilts? The key here will be the attitude of the next Chancellor. If Labour does get in, the first Budget of the new government will be scrutinised for any use of mirrors to make the figures look better. My guess is that come what may, gilts will have a difficult year, but if there is the prospect of tighter fiscal policy under Labour than under the Tories, then come 1998 the prospects will look much brighter.

The impact on the pound? Well, the problem here is that a lot of that impact is already in the market: sterling shot up in the final quarter of last year and from being clearly undervalued is now close to its underlying purchasing power parity. Of course currencies can, and do, overshoot. It is perfectly possible that sterling will become too strong during the course of this year. In any case there are two sides to the currency equation and whatever happens to the pound will be determined by what happens to the dollar and/or the German mark. A rational expectation would be for sterling to continue to strengthen through the early part of this year but for that rise to peak by mid-year. But the forex markets are not noted for their reason, and in any case, with the preparations for EMU they will have bigger fish to fry.

In the US, still the dominant market for the world, there will also be a rise in interest rates. The Federal Reserve has its next policy meeting in early February by which stage it will be clear how sustained the present acceleration is growth is likely to be. The bigger question will be later in the year: will the long expansion in the US come to an end of its own accord or will there have to be several rises in rates to choke it off. Mainstream expectation: a couple of further rises in US rates during the course of this year, but no savage tightening. Providing the Fed does act in February there need be no fall-out in the bond market, but at best bond yields will move sideways.

But that does not mean that the 15 year long-term downward trend of bond yields, in the US as well as in continental Europe, is ended. As the graph shows this is a solid long-term trend. Now at some stage that will end once it becomes clear that the downward trend in inflation cannot proceed any further. But this year I think we just see a pause on that downward path.

The dollar? Probably some more strength, as the gradual, patchy recovery continues. But the main influence on the dollar will be what happens to the European currencies. If the euro is going to be a weak currency, as now seems more and more likely, then the dollar's safe haven status will be enhanced. If plans for the EMU fall to bits - maybe not likely but certainly possible - then expect the mark to resume its status as the world's "best" currency.

And so to continental markets. Here the rise in interest rates will not happen until well into the autumn, maybe not till 1998.

Bond markets will take courage from this, but currencies will struggle.

The single biggest question for bonds and currencies is whether the long-term downward trend of inflation really solid? I think it is. If so, expect a stormy year but with calm water beyond.

Start your day with The Independent, sign up for daily news emails
News
people
News
A boy holds a chick during the Russian National Agricultural Exhibition Golden Autumn 2014 in Moscow on October 9, 2014.
news
Life and Style
love + sex
Sport
Ashley Young celebrates the winner for Manchester United against Newcastle
footballNewcastle v United 1 player ratings
Arts and Entertainment
Victoria Wood, Kayvan Novak, Alexa Chung, Chris Moyles
tvReview: No soggy bottoms, but plenty of other baking disasters on The Great Comic Relief Bake Off
Sport
Ashley Young celebrates the winner for Manchester United against Newcastle
footballNewcastle 0 Man United 1: Last minute strike seals precious victory
ebooks
ebooksA special investigation by Andy McSmith
Life and Style
Tikka Masala has been overtaken by Jalfrezi as the nation's most popular curry
food + drink
Arts and Entertainment
Seth Rogan is one of America’s most famous pot smokers
filmAmy Pascal resigned after her personal emails were leaked following a cyber-attack sparked by the actor's film The Interview
News
Benjamin Netanyahu and his cartoon bomb – the Israeli PM shows his ‘evidence’
people
Arts and Entertainment
80s trailblazer: comedian Tracey Ullman
tv
News
i100
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Ashdown Group: Graduate Application Support Analyst

£25000 - £30000 per annum + benefits: Ashdown Group: A global leader operating...

Reach Volunteering: External Finance Trustee Needed!

Voluntary post, reasonable expenses reimbursed: Reach Volunteering: Would you ...

Christine McCleave: FP&A Analyst

£36,000 - £40,000: Christine McCleave: Are you looking for a new opportunity a...

Recruitment Genius: Sales Executive - OTE £40,000

£15000 - £18000 per annum: Recruitment Genius: This is a great opportunity for...

Day In a Page

War with Isis: Iraq's government fights to win back Tikrit from militants - but then what?

Baghdad fights to win back Tikrit from Isis – but then what?

Patrick Cockburn reports from Kirkuk on a conflict which sectarianism has made intractable
Living with Alzheimer's: What is it really like to be diagnosed with early-onset dementia?

What is it like to live with Alzheimer's?

Depicting early-onset Alzheimer's, the film 'Still Alice' had a profound effect on Joy Watson, who lives with the illness. She tells Kate Hilpern how she's coped with the diagnosis
The Internet of Things: Meet the British salesman who gave real-world items a virtual life

Setting in motion the Internet of Things

British salesman Kevin Ashton gave real-world items a virtual life
Election 2015: Latest polling reveals Tories and Labour on course to win the same number of seats - with the SNP holding the balance of power

Election 2015: A dead heat between Mr Bean and Dick Dastardly!

Lord Ashcroft reveals latest polling – and which character voters associate with each leader
Audiences queue up for 'true stories told live' as cult competition The Moth goes global

Cult competition The Moth goes global

The non-profit 'slam storytelling' competition was founded in 1997 by the novelist George Dawes Green and has seen Malcolm Gladwell, Salman Rushdie and Molly Ringwald all take their turn at the mic
Pakistani women come out fighting: A hard-hitting play focuses on female Muslim boxers

Pakistani women come out fighting

Hard-hitting new play 'No Guts, No Heart, No Glory' focuses on female Muslim boxers
Leonora Carrington transcended her stolid background to become an avant garde star

Surreal deal: Leonora Carrington

The artist transcended her stolid background to become an avant garde star
LGBT History Month: Pupils discuss topics from Sappho to same-sex marriage

Education: LGBT History Month

Pupils have been discussing topics from Sappho to same-sex marriage
11 best gel eyeliners

Go bold this season: 11 best gel eyeliners

Use an ink pot eyeliner to go bold on the eyes with this season's feline flicked winged liner
Cricket World Cup 2015: Tournament runs riot to make the event more hit than miss...

Cricket World Cup runs riot to make the event more hit than miss...

The tournament has reached its halfway mark and scores of 300 and amazing catches abound. One thing never changes, though – everyone loves beating England
Katarina Johnson-Thompson: Heptathlete ready to jump at first major title

Katarina Johnson-Thompson: Ready to jump at first major title

After her 2014 was ruined by injury, 21-year-old Briton is leading pentathlete going into this week’s European Indoors. Now she intends to turn form into gold
Syrian conflict is the world's first 'climate change war', say scientists, but it won't be the last one

Climate change key in Syrian conflict

And it will trigger more war in future
How I outwitted the Gestapo

How I outwitted the Gestapo

My life as a Jew in wartime Berlin
The nation's favourite animal revealed

The nation's favourite animal revealed

Women like cuddly creatures whilst men like creepy-crawlies
Is this the way to get young people to vote?

Getting young people to vote

From #VOTESELFISH to Bite the Ballot