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Wednesday, Jun 09, 2004

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Market overpricing Fed tightening?

S. Balakrishnan

INFLATION worries are back on the front pages of financial papers and market commentaries.

We seem to have touched the bottom of the inflation cycle, both globally and in India. US inflation, excluding the components of fluctuating food and energy prices, is still below 2 per cent for the last year, but showed a sharp jump in April data. Many are predicting that it will increase to (an annualised) 3 per cent in the next twelve months. This is also reflected in the about 3 per cent yield differential between straight and inflation-indexed Treasury bonds.

The domestic picture, while far from alarming, needs close watching. The latest figure shows that the point-to-point WPI in 2003-04 was a little over 5 per cent. The yield on the 10-year gilt was only around 5.25 per cent, so that in inflation-adjusted terms, it was barely positive. Nowhere as good as the US, where the real return is still well over 2 per cent.

It is hardly surprising that central banks around the world have shifted from soft to neutral to hardening mode on interest rates.

Britain, Australia and New Zealand have already tightened policy. Their interest rates, at 4.25 per cent and 5.25 per cent, are among the highest in the G-8 economies. The frontrunner for the next move in central bank sweepstakes is the US Federal Reserve, which meets on June 29 and 30. A rate increase is considered a dead cert. The reasons are simple.

The job market is turning around, with close to a million jobs being created in just the last three month. Till April, employment looked anything but robust, despite all other indicators pointing an extremely rosy picture of the economy and provoked Mr Alan Greenspan and his FOMC colleagues to virtually commit themselves to holding rates till a noticeable and sustained improvement in jobs.

That has probably happened now. The Fed will increase rates 25 basis points, possibly even 50 basis points, if the upcoming data on inflation and retail sales point to rising prices and strength in consumer spending.

What after that? The US yield curve has steepened considerably in the last weeks, both at the short and long ends. Ten-year Treasuries are hovering around 4.75 per cent, while two years are yielding 2.65 per cent. More significant is the market's perception of the pace of Fed moves. It thinks 6-month Libor will be no less than 2.75 per cent at the end of this year, compared to 1.6-1.7 per cent now, implying Fed Funds will rise to 2 per cent by then - 100 bps more than now.

Is it likely? The giveaway is in the language of the post-meeting statement after the last Fed meeting, which talks about a "measured pace" of rate increases.

Clearly, the Fund will not "anticipate" inflation and push up rates in advance and in fear of something, which may never materialise. Almost to a man (surprisingly), the FOMC thinks price pressures will not surface, given the slack in factories and labour and competition from imports, which will prevent businesses form raising prices.

In which case, markets are overpricing Fed tightening. No wonder, two and three-year Treasury yields and swap rates are looking attractive.

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