• Investment World
• eWorld
• Catalyst
• Mentor
• Life
• Canvas
• Praxis
• Urban Pulse
• Brand Quest

V. Anantha Nageswaran

THE US Federal Reserve Open Market Committee (FOMC) left the target for the federal funds rate unchanged at 1 per cent. It was not a surprise. Their communication too was quite similar to the one that they released after the August meeting minutes. The second para was identically similar. The first para had an interesting and important twist.

In August, the Fed believed that labour market indicators were mixed. Now, they believe that between their last meeting in August and the one held yesterday, the labour market has weakened. It is a clear admission that the labour market has de-coupled from the temporary short-term momentum in the American economy. The decision by DaimlerChrysler to close several plants manufacturing auto components in the US is a reminder of how challenging the labour market environment in the US is.

This lends a touch of credibility to their commitment to maintain interest rates at low levels. Although the bond market did not react significantly to the decision, it is likely to do so in the coming weeks. The consumer price index data released earlier in the day underscores the Fed commitment to keep interest rates low. Core consumer price inflation dipped to 1.3 per cent from 1.5 per cent the month before.

Mr Greenspan would remember the criticism of being `too tight' in 1990-91

Some in the Republican Party felt that Chairman Greenspan did not `help' the re-election efforts of George Bush, Sr. by not easing interest rates quickly enough in 1990-91. Whether or not that criticism has any merit, Chairman Greenspan would be mindful of that criticism too. At the margin, this would be another reason for the Federal Reserve not to tighten in haste. Indeed, continued labour market weakness would even cause the Fed to lower the Federal funds rate to between 0.50-0.75 per cent in the first quarter of next year.

Investment implications

Stronger bonds and stronger equities

Much as we recognise the valuation constraint for US equities, we recognise that a party is going on and that it is bound to get stronger if the bond market attaches greater credibility to the Federal Reserve commitment to keep interest rates low or even lower them, if necessary. Indeed, even before the Federal Reserve met, interest rate futures had begun to rise in price. The FOMC has lent greater force to the trend by recognising labour market weakness.

Therefore, it is highly likely that we have seen the highs for the US 10-year Treasury yield in this cycle. Before the end of the year, we are quite likely to see US 10-year Treasury yield below 4 per cent, quite comfortably.

This is going to underpin US equities as future earnings are discounted at lower bond yields. Falling bond market yields supported equities in the second quarter. It is likely to do so again in the coming months. In fact, one major difference is that the economy appeared weak in the second quarter and, yet, stocks rallied with the support of rapidly declining bond yields. Now, with third quarter profits likely to surprise on the strong side, lower bond yields would provide an additional kick to equity upside.

Indeed, it is possible that the S&P 500 index rises to a level of between 1120-1160. That would complete a 50 per cent recovery from the lows of 776 reached in October 2002. It would be similar to the 51 per cent rally in the Tokyo TOPIX index from the low of 1,124 in August 1992 to a high of 1700 in September 1993. Strength in the S&P 500 would reverberate in other markets as well. The Nikkei 225 should make an assault on 12,000, as would the Mumbai Sensex Index at 5,000.

Weaker dollar

As the bond market takes the Fed commitment to keep rates at low levels seriously, the market would begin to re-evaluate the interest rate differential between the US dollar and other currencies. We have argued early this month that the bulk of the correction in the euro against the US dollar could be traced to the market pricing out the higher interest rate differential in favour of the euro, by the end of next year. We expect that it would be priced back in, in the course of the next few months. However, in an environment of improved risk appetite, the euro would underperform other currencies with a bigger interest rate support such as the AUD, GBP and CAD. Euro strength would likely be capped at around 1.15-1.16 in the final months of the year.

Similarly, the Canadian economy has begun to re-exhibit signs of economic strength that were temporarily hidden by the SARS outbreak in the country. Data since the beginning of the month — industrial production, new vehicle sales, building permits and housing starts — have exceeded expectations. Canadian dollar Treasury yield curve lies well above the US, indicating a good yield pick-up in Canadian dollar together with currency appreciation potential.

Gold strength to continue

Gold is consolidating after a heady rise up to $382 per ounce. We expect the uptrend to continue particularly coinciding with renewed US dollar weakness. The steadily increasing rhetoric around the world for weaker currencies and the worsening geopolitical environment solidify the case for gold. It would not surprise us if we see Gold at $400 before the year is out.

Postscript

It is important not to forget that a 50 per cent rise in the S&P 500 from the lows of October 2002 does not signal the end of the bear market. Such a rise was seen in Japan too before the index breached newer lows several years later.

At some level, it can be argued that the US economy has far greater problems than Japan, notably the private sector savings deficit. Japan did not have to depend on foreigners to finance an expanding government. It does not do so, even now. The US does and increasingly so. That is a crucial difference between the two economies, resulting in more difficult times for American equities this decade compared to what Japanese equities experienced in the previous one.

The global society has become less safe now and the global economy has become less integrated than last year with protectionist and isolationist tendencies on the rise. This is being seen in the clamour for currency weakness and in entrenched positions in world trade talks.

Thus, the longer and wilder the party in 2003, the more painful the hangover will be in 2004.

(The author is Director, Global Economics and Asset Allocation in Credit Suisse Asia-Pacific. His comments are personal. Feedback can be sent to anantha@nageswaran.com)

Article E-Mail :: Comment :: Syndication

Stories in this Section
Powering a tariff policy

Copyright © 2003, The Hindu Business Line. Republication or redissemination of the contents of this screen are expressly prohibited without the written consent of The Hindu Business Line