Uneasy calm before the storm: Alan Greenspan has allayed some fears but markets are still worried about rates. Peter Torday reports

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THERE is likely to be palpable relief that Alan Greenspan, the sphinx-like chairman of the US Federal Reserve, has been so skilful in calming world financial markets when finance ministers and central bankers of the Group of Seven meet in Germany this Saturday,

The bulk of the meeting will in any case be devoted to the deteriorating Russian economy. Theo Waigel, the German finance minister hosting the talks, has invited a clutch of top Russian ministers, International Monetary Fund and World Bank officials and a senior European Union commissioner.

Had Mr Greenspan not been so successful in ending the squall that has afflicted world bond and equity markets since early February, it would have been an uneasy meeting. Discussions would have focused on Russia but minds would have been distracted by world markets.

As it is, Mr Waigel has set aside some time for talks on the world economy, and he is worried that US-Japan trade frictions may emerge to dominate the talks.

The group would do well to worry about the markets because, despite Mr Greenspan's efforts to allay fears about sharp rises in US rates, the markets are starting to sense the turn in the global interest rate cycle. Apart from anything else, that means the cost of financing high budget deficits will mount and step up pressure for more taxes and spending cuts back home.

'The US bond market has now completely changed its view of the world,' says Ian Harwood, head of global asset allocation at Warburg Securities. 'People are worried by demand-pull (demand created) inflation. As long as the US economy stays strong, the bond markets are going to keep worrying.'

In Europe, meanwhile, Mr Harwood says that although economic fundamentals still point to lower short-term rates, the bull run is probably reaching an end. 'It is now a two-way market and people are beginning to realise that budget deficits are out there.'

Jim O'Neill, managing director of financial markets research at Swiss Bank Corporation, takes a similar view. 'Although Greenspan calmed things down, the Fed is slowly starting to engineer higher interest rates in the US and the only element of doubt is when.'

Much hinges on whether the US economy sustains the heady growth rates of the fourth quarter - likely to have reached 7 per cent at an annual rate. Many, including the Fed, believe that it will slow. But since the Fed is focusing monetary policy on inflation pressures in 1995 and beyond, when growth may well accelerate, the markets could have grounds for concern.

Many analysts in Europe, meanwhile, believe the European interest rate cycle is decoupled from the US because the Continental economy has yet to emerge from recession.

Although that could well be the case for short-term rates, the events of the past few weeks suggest otherwise for long-term rates. Rising US bond yields have pulled up long- term rates in Germany and Britain.

European analysts rightly expect further cuts in short-term rates on the Continent but there are indications that hopes of deep reductions may be overdone.

The shock came on 4 February when the Fed lifted the Fed Funds rate a quarter point, to 3.25 per cent, the first such increase in five years. At the time, the prevailing view in the UK was that base rates still had significant room to fall. That view has altered in the past few weeks.

A majority of the Treasury's independent panel of advisers, the six wise men, now think a further cut in rates is unnecessary. And the markets are not pointing decisively to a further drop, even though many analysts still look for rates to fall below 5 per cent.

As for Germany, the markets reacted badly to the latest half-point cut in the discount rate, to 5.25 per cent, partly because the Bundesbank left the securities repurchase rate - which sets the tone for market rates - unchanged at 6 per cent. Though German rates are expected to fall further, hopes of a slide to 4 per cent or less are likely to be disappointed.

The last time the German discount rate slumped to 3 per cent - in 1986 - inflation was negative. This time around, the Bundesbank is unlikely to squeeze inflation back from 3.5 per cent to its long-term aspiration of 2 per cent, according to Thomas Mayer of Goldman Sachs. As a result, Mr Mayer and others expect the discount rate to trough at a higher point than in the mid- 1980s.

'The Bundesbank is going to keep disappointing people,' says Mr Harwood at Warburg. 'People are starting to realise that the world is not slipping back into recession and green shoots are appearing in Europe.'

With Mr Greenspan's timely intervention during Congressional testimony earlier this week, some economists look for a renewed rally in European bonds, triggered by the Bundesbank's next cut in the repo rate. It is equally possible that the US bond market might recover its poise. But all this looks like the tail end of the party enjoyed by global bond and equity markets in an almost unbroken run since last August.

The first real challenge to a renewed bond market rally will come when the Fed next tightens monetary policy. David Cocker, economist at Chemical Bank, worries that the Fed will raise the Fed Funds rate as early as next month.

In the meantime, financial markets face potential upheaval from deepening US-Japan trade friction. US officials indicate privately that they intend to take the issue to the brink, with all the attendant risks for the markets.

For the past few weeks, rumours of Japanese institutions dumping US Treasury bonds were widespread. If there was even a scintilla of truth to such speculation it would be worrying. Japanese institutions are thought to hold a substantial portion of the roughly 20 per cent of US government debt, or dollars 567bn, held in foreign private hands. Though unsubstantiated, these reports mirror at the very least worries that the trade friction could destabilise the markets.

(Photograph and graph omitted)