The Fed keeps it down - for the meantime

Financial markets breathed a sigh of relief last week when the US Federal Reserve, its central bank, opted to leave the key Fed funds rate - the equivalent of the UK base rate - unchanged at 5.5 per cent.

That relief, however, looks like it will prove short-lived.

European bonds are expected to outpace US Treasuries in the coming months, as investors and economists expect Fed chairman Alan Greenspan, arguably the most important figure in global financial markets, to sanction a rise in interest rates when he next meets his fellow Fed members in July.

With a US rate rise likely to make European bonds a better buy than Treasuries, the yield premium investors charge the US government to borrow, compared with what it charges the German government, is set to rise to the highest it's ever been.

"I suspect US rates will still have to go up at some stage, so I'm still reasonably negative on the US bond market," said Bipin Shah, senior portfolio manager for Manulife International Investment Management.

Benchmark 10-year US bonds currently yield about 95 basis points more than German bonds, not far from the average of 90 seen in the past six months. That's down from a closing high of 107 basis points reached on 4 March.

Investors, however, say they're expecting to charge Uncle Sam more for his money in future.

"I would say it's getting more and more likely we'll see the spread move out to the 125 basis point area," said Gerd Neitzel, fund manager for Siemens in Munich. "I'm not so much of a pessimist that I think we'll see a spread of 150, though."

Not only is the US economy the world's biggest, its bond market is the biggest and most liquid debt market in the world.

If US bonds sneeze, European bonds start reaching for the Kleenex.

The yield on the 30-year Treasury bond, the bellwether for world bond markets, hasn't budged much since the Fed left interest rates on hold. US bond specialists had been split 50/50 on whether the Fed would raise.

The yield is currently about 6.96 per cent, up 4 basis points since the Fed meeting, and at the same level it reached on 25 March when the Fed raised rates by a quarter-point - the first US rate rise for more than two years.

It won't last.

"We're not that positive on the US market here," said Paul Cavalier, a fund manager at Lombard Odier Investment Management. "I think the market will set itself up for a rate hike in July. We're not out of the woods yet."

Cavalier said he's expecting bond yields in both Europe and the US to rise over the next few months, though European governments won't face the same rise in borrowing costs as the US. "I believe European bond prices will follow Treasuries down, but with a lag," he said.

Low growth, low inflation and low interest rates are good news for bondholders. The US economy may pick up enough speed to spur Greenspan into raising rates - and spook investors out of his bond market.

While the German economy is improving, growth remains weak and inflation low. German M3 money supply growth, the Bundesbank's key indicator for setting its interest rates, grew at an annual rate of 6.7 per cent in April, down from 8.3 per cent in March and below the 7.7 per cent expansion anticipated by economists in a Bloomberg survey.

The Bundesbank has said it wants to keep interest rates in Germany at their current historic lows for as long as possible. The central bank's last move on rates was way back in August 1996, when it sliced 0.3 per cent from its key 14-day official repurchase rate, cutting it to an all- time low of 3 per cent.

Moreover, the Bundesbank isn't likely to have to worry about inflation- curbing rate rises until much later in the year at the earliest.

"Bunds will outperform Treasuries for the next few months, until the speculation switches to when the Bundesbank will raise rates towards the end of the year," said Holger Schmieding, an economist at Merrill Lynch Bank in Frankfurt.

A likely trigger for a US rate rise is the May US employment report scheduled for release on 6 June, which is likely to boost the 850,000 jobs the US economy added in the first four months of the year.

Alan Greenspan has emphasised his concern that if there are enough jobs around to make workers confident enough to demand the kinds of wage rises which could lead to higher inflation, he'll jack up rates.

"The employment gain in May this year could be close to 300,000, well above the 218,000 average so far this year," said Kevin Logan, a strategist at Dresdner Kleinwort Benson in New York. "If it is, the bond market will get defensive again over fear of a Fed rate hike."

If the Fed does decide it needs to raise rates, investors are praying it won't spark a rerun of 1994, when six rate rises in less than a year pushed the Fed funds rate to 5.5 per cent from 3 per cent, sparking a financial bloodbath that drove 10-year US bond yields up by almost 250 basis points.

Annual US consumer price inflation of 2.5 per cent is higher than Germany's 1.7 per cent rate, though not high enough to spark concern about inflation eroding the return on bonds, economists said.

Nevertheless, with the Fed expected to affirm its commitment to keeping future inflation low with a rate rise in six weeks' time, European bonds are expected to prove a better investment than Treasuries for the time being.

"We believe the US economy remains on a well-balanced path that should permit the expansion to keep rolling ahead, but another 'insurance' installment from the Fed would have reinforced that conviction for the financial markets," said Bruce Steinberg, chief economist at Merrill Lynch in New York. "We would look to a tightening at the July meeting." Copyright: IOS & Bloomberg

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