RSS feedsThe financial markets were in acute turmoil in late November. The US dollar fell sharply, touching multi-year lows against the euro, sterling and yen. Yields on 10-year US treasury bonds fell further and were 70 basis points below their June level. The inversion of the US and UK yield curves became more pronounced and the eurozone yield curve was temporarily inverted for the first time in six years. Oil prices fell towards $55/barrel. These events worsened fears that growth would plummet and heightened pressures for early interest rate cuts.
The mood changed since the second week of December, as better than expected US figures on jobs, retail sales and trade backed the Fed’s view that the threat of downturn is exaggerated. Though US inflation figures for November were benign and lower than predicted, the markets abandoned their former deep growth pessimism. The dollar and bond yields rose from their previous lows. Oil prices approached $65/barrel. The central banks have won new flexibility. The Fed will not be forced to cut rates too early. The ECB will be able to tighten further. But the economic realities remain much more stable than the abrupt swings in market mood may signal.
Rates
The Fed left its rate at 5.25% on 12 December, but it still considers inflation
a bigger worry than weak growth. The markets expect US rates to stay at 5.25%
for a few months, with the next move a cut to 5% before mid-2007.
In Europe, the ECB raised rates 3.5% on 7 December and signalled more increases. ECB rates are likely to peak at 3.75% in Q1 or Q2 2007.
The Bank of England left rates at 5%. But pressure for a further early increase to 5.25% has lessened and the markets now expect the next UK move to be a cut in Q2.
The Bank of Japan may raise rates in January, while China perseveres with a policy of gradual but controlled currency appreciation to limit US protectionist pressures.
Massive global imbalances will unleash new threats to growth in 2007 and currency instability will recur even if recession is avoided. The 2007 landing, though not very hard, will be bumpy. The central banks must avoid damaging monetary “overkill”.
