The Hindu Business Line : End of the global monetary tightening?

BY ALL accounts, it seems the week ended April 15, will be critical for global financial markets in the immediate future. It may have thrown up enough hints about the course the major financial markets — be it global exchange rates, interest rates, other asset prices — would take in the next half year or so. And from that one can also make some reasonable forecasts about the domestic financial markets — rupee interest rates and its exchange rate.

For the record, it would serve to recapitulate some of the possible trend-setting developments of the April 15 week. Stock markets globally crashed (some indices such as the S&P 500 and the Dow Industrials touched two-year lows) on concerns over high oil prices; weakened/weakening consumer confidence, and sluggish economic performance substantially scaling down earnings in the ensuing period.

Bonds, led by bellwether US Treasuries, rallied strongly on the back of the overall economic weakness. Benchmark 10-year Treasuries closed the week at 4.24 per cent. Two-year US note yields were also sharply lower (around 25/30 bps) at around 3.50 per cent.

Ten-year notes had touched 4.69 per cent on March 23 and were generally forecast to rise above 5 per cent in the second half of the year. The median yield forecast for the end of this year in a January survey of the 22 primary dealers in US Treasury securities was 5 per cent, the highest level in almost three years.

These developments in the US financial markets — particularly in bonds — can have an electrifying effect (or to put it more appropriately, a soothing effect) on bond markets globally.

More important, these developments indicate the end of the current phase of global monetary tightening. The US Federal Reserve will possibly pause now, with the Fed Funds rate at 2.75 per cent — up from 1 per cent in mid 2004 on the back of seven successive rate hikes of 25 bps each — or at most push through another hike to 3/3.25 per cent.

The interest rate forward markets (futures on interest rates) have also scaled down their expectations of where Fed funds would be by the end of the year to 3.75 per cent (down from 4 per cent). But if the scale of the move in the cash market for Treasuries is any indication, it is unlikely that there is a further revaluation of prices in the futures market.

Macro-economic message

The concern about the recent weakness in economic activity has been so strong that G7 finance ministers and central bankers, after their just-concluded meet, have talked of "vigorous action" to counter it. And it needs no economist to figure out that further interest rate hikes are certainly not the vigorous action the G7 has in mind to counter the dampened economic activity.

Indeed, further interest rate hikes are almost certainly ruled out as they could exacerbate the weakness in consumer spending/sentiments and in business investment.

The broader message is in the area of macro-economic management. It is possible that we will see a reduced emphasis on monetary policy action (tightening) to counter price pressures brought on by supply-side shocks.

Developments over the past year and a half in the prices of key consumption/industrial commodities such as crude oil/metals — rising well above even the levels warranted by substantially higher demand in key consuming nations such as China and India — and their impact on the overall inflation indices are now well-known.

It is also well known that the US Fed put through a series of seven rate hikes right across the phase when oil prices were being driven to all-time highs by a combination of genuine demand/speculative pressures.

The overt tightening stance of the Fed, in turn, led many other central banks (of course, with some exceptions) also to go the same way. Domestic financial markets (of interest rate, in particular) in various countries, such as India, in turn, had to price in this stance of their central banks.

With the notable weakening now noticed in various indices of economic activity — on the consumption side, on the investment side, etc — macro-economic management may now take a different tack. We could well see more direct attempts to ease the supply-side shocks and constraints. But to the extent that there is a premium on the prices of key supplies brought on purely by speculative or geopolitical factors, one has to keep fingers crossed on how successful such direct attempts could be.

The immediate future

But at the level of the financial markets, we may see relief from various central banks in the immediate future. This could mean, for instance, that benchmark Indian bond yields (10-year G-secs) do not rise above 7 per cent — the key level they touched in the past couple of weeks and could decline at least a half percentage point in the immediately ensuing period. The pressure on other segments of the interest rate market — be it bank deposit, lending, and other money market rates — will consequently weaken as we go ahead.

The Reserve Bank of India Governor recently pointed out that the Indian economy/financial markets were neither fully open nor fully closed. They were in the process of "opening up", he said.

This "opening up" process would appear to impart a "best of both worlds" feature to our markets. While global monetary tightening would not automatically lead to higher Indian interest rates of the same magnitude, softening global monetary policy would appear to provide that additional downward momentum.

In bond market parlance, the Indian financial markets would seem to exhibit quite a degree of convexity.

(The author is Associate Vice-President — Treasury — ING Vysya Bank Ltd. These views are personal and do not represent those of his employer.)

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