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S. Balakrishnan

THE question now engaging the best and the brightest in financial markets the world over is how interest rates will play out for the rest of this year.

As in most things, all eyes are focused on the US. When will Mr Alan Greenspan, the Chairman of the US Federal Reserve, make his move? And by how much? Will it mark the beginning of serial rate rises?

There is a noticeable change in Mr Greenspan's language in recent months. The first half of 2003 saw the Fed chief and his colleagues on the Federal Open Markets Committee (FOMC), which sets US interest rates, exercised about the prospect of deflation gripping the American economy.

Japan is the world's deflation icon, and the fear of contracting Japan's disease became so pervasive that yields on 10-year Treasuries sank to just about 3 per cent in the middle of last year. That worry is now gone. In his testimony last week, Mr Greenspan spoke of "pricing power" returning to producers, but still saw no evidence of broad-based inflation.

Clearly, the crash in yields was overdone. They starting bouncing back, though the Fed continued to see deflation risk slightly outweighing the prospect of prices rising in its meetings through the latter half of 2003. Despite this, 10-year Treasury yields hit the 4.75-per cent levels, after which came another big fall to below 3.75 per cent, because of strong foreign demand and buying of US Government bonds with dollars obtained from currency market intervention to check the appreciation of yen and other Asian currencies.

Even disinflation — which means falling inflation (and must be distinguished from deflation which refers to falling prices) — "has ceased," according to FOMC member, Mr Roger Ferguson. Translation: Get ready for higher prices. Possibly, the most important pronouncement from any Fed official in the recent past.

What's in store? A slew of data — QI GDP, payrolls, retail sales and CPI being the key ones — is due in the next fortnight or so. But more or less overriding everything is the FOMC meeting on May 4.

As usual, the post-meeting statement will be the cynosure of all eyes, for no one seriously thinks the Fed will act on rates now. It might take the view the balance of risk is now tilted slightly towards inflation and there is need to be vigilant about it.

Coupled with good economic numbers, this might seem the perfect recipe for a sell-off in bond markets in the next few weeks. Barring event risk, brace for 10-year Treasuries hitting the region of 4.75-5 per cent with more or less parallel movements all along the curve.

More Stories on : Govt Bonds | Financial Scan | Interest Rates

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