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
ebooksNow available in paperback
Scunthorpe goalkeeper Sam Slocombe (left) is congratulated by winning penalty taker Miguel Llera (right)
Life and Style
A woman walks by a pandal art installation entitled 'Mars Mission' with the figure of an astronaut during the Durga Puja festival in Calcutta, India
techHow we’ll investigate the existence of, and maybe move in with, our alien neighbours
Arts and Entertainment
Sir Ian McKellen tempts the Cookie Monster
tvSir Ian McKellen joins the Cookie Monster for a lesson on temptation
Tourists bask in the sun beneath the skyscrapers of Dubai
travelBritish embassy uses social media campaign to issue travel advice for festive holiday-makers in UAE
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

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

iJobs Job Widget
iJobs Money & Business

Ashdown Group: Marketing Services Manager - (communications, testing, DM)

£32000 - £35000 per annum + benefits: Ashdown Group: Marketing Services Manage...

Guru Careers: Finance Account Manager

£Neg. (DOE) + Excellent Benefits: Guru Careers: A Finance Account Manager with...

Ashdown Group: Java Developer - Hertfordshire - £47,000 + bonus + benefits

£40000 - £470000 per annum + bonus: Ashdown Group: Java Developer / J2EE Devel...

Ashdown Group: Direct Marketing Manager - B2C, Financial Services - Slough

£45000 - £55000 per annum + Benefits: Ashdown Group: An exciting opportunity h...

Day In a Page

Jeb Bush vs Hillary Clinton: The power dynamics of the two first families

Jeb Bush vs Hillary Clinton

Karen Tumulty explores the power dynamics of the two first families
Stockholm is rivalling Silicon Valley with a hotbed of technology start-ups

Stockholm is rivalling Silicon Valley

The Swedish capital is home to two of the most popular video games in the world, as well as thousands of technology start-ups worth hundreds of millions of pounds – and it's all happened since 2009
Did Japanese workers really get their symbols mixed up and display Santa on a crucifix?

Crucified Santa: Urban myth refuses to die

The story goes that Japanese store workers created a life-size effigy of a smiling "Father Kurisumasu" attached to a facsimile of Our Lord's final instrument of torture
Jennifer Saunders and Kate Moss join David Walliams on set for TV adaptation of The Boy in the Dress

The Boy in the Dress: On set with the stars

Walliams' story about a boy who goes to school in a dress will be shown this Christmas
La Famille Bélier is being touted as this year's Amelie - so why are many in the deaf community outraged by it?

Deaf community outraged by La Famille Bélier

The new film tells the story of a deaf-mute farming family and is being touted as this year's Amelie
10 best high-end laptops

10 best high-end laptops

From lightweight and zippy devices to gaming beasts, we test the latest in top-spec portable computers
Michael Carberry: ‘After such a tough time, I’m not sure I will stay in the game’

Michael Carberry: ‘After such a tough time, I’m not sure I will stay in the game’

The batsman has grown disillusioned after England’s Ashes debacle and allegations linking him to the Pietersen affair
Susie Wolff: A driving force in battle for equality behind the wheel

Susie Wolff: A driving force in battle for equality behind the wheel

The Williams driver has had plenty of doubters, but hopes she will be judged by her ability in the cockpit
Adam Gemili interview: 'No abs Adam' plans to muscle in on Usain Bolt's turf

'No abs Adam' plans to muscle in on Usain Bolt's turf

After a year touched by tragedy, Adam Gemili wants to become the sixth Briton to run a sub-10sec 100m
Calls for a military mental health 'quality mark'

Homeless Veterans campaign

Expert calls for military mental health 'quality mark'
Racton Man: Analysis shows famous skeleton was a 6ft Bronze Age superman

Meet Racton Man

Analysis shows famous skeleton was a 6ft Bronze Age superman
Garden Bridge: St Paul’s adds to £175m project’s troubled waters

Garden Bridge

St Paul’s adds to £175m project’s troubled waters
Stuff your own Christmas mouse ornament: An evening class in taxidermy with a festive feel

Stuff your own Christmas mouse ornament

An evening class in taxidermy with a festive feel
Joint Enterprise: The legal doctrine which critics say has caused hundreds of miscarriages of justice

Joint Enterprise

The legal doctrine which critics say has caused hundreds of miscarriages of justice
Freud and Eros: Love, Lust and Longing at the Freud Museum: Objects of Desire

Freud and Eros

Love, Lust and Longing at the Freud Museum