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Thursday October 6, 2005 - 14:45:55 GMT

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Greed and fear

Yield plays have become more important over the past few weeks as funds have been tempted by high-yield assets. Interest rate trends will remain important and further US interest rate increases are certainly realistic on a short-term view. Higher interest rates will tend to attract further funds into the US dollar and other high-yield assets such as the Australian dollar. There will also be a generally weak level of interest in low-yield instruments such as the yen and Euro.

While investor confidence in the dollar, global growth and equity markets remains strong, there will be a willingness to take on the perceived extra risk for fear of losing out on extra yield. There will also be confidence that additional risks on high-yield assets will be relatively low. The equation could, however, change very quickly if confidence in the US falters and the yield premium would then be seen in a very different light. Fears over capital losses would tend to overshadow the yield attractions.

The global central banks will also face a very difficult task in balancing the needs of curbing inflation, deflating housing markets gradually and avoiding a sharp slowdown in growth. If wider inflation levels rise or growth starts to weaken, there would be a much stronger interest in defensive currencies and fears over capital losses in high-yield markets would increase. Overall, there are significant risks that the yield chasing will tend to reverse within the next few months as a whole as market risk premiums are liable to increase. This should offer support to the Euro, yen and Swiss franc.

Yield factors important

Over the past few weeks, there has been a further shift of funds into higher-yielding assets and demand for defensive currencies has remained weak. There has been some tentative signs of a shift in this trend over the past few days with the Swiss franc regaining some ground while higher-yielding central European currencies have tended to weaken against the Euro.

The Euro, Swiss franc and yen have all weakened over the past month while there have been gains for most higher-yielding currencies. High-yield emerging market instruments have also been in demand and the US dollar has also benefited from being seen as a higher-yielding currency following 11 successive Federal Reserve interest rate increases.

After a brief reversal in expectations following hurricane Katrina, the markets are confident that the US Federal Reserve will continue to push short-term US interest rates higher. Short-term US interest rates were increased to 3.75% in September and markets have priced in a further increase to at least 4.25% with some estimates pointing to a peak of at least 5.0% next year. Fed officials have voiced greater concerns over inflation and this is compounding expectations of higher interest rates.

Real yields in focus

Energy prices remain high and this will continue to put upward pressure on headline inflation rates.

There is a danger that central banks have allowed excess liquidity creation over the past few years and that this will lead to a more general increase in inflation through the secondary impact of strong rises in financial assets such as house prices. Although this would tend to maintain upward pressure on nominal yields, the higher inflation forecasts and expectations would damage real-terms yields. Real yields remain the crucial market perspective on a medium-term view and any sustained increase in inflation would, therefore, tend to weaken demand for high-yield currencies even if nominal rates continue to increase.

Growth also in doubt

There is the risk that the combination of rising energy costs and higher short-term interest rates will undermine growth prospects. In this context, the US economy still looks vulnerable given the high level of household debt and the substantial amount of cash released through the housing sector. The Federal Reserve will face a very tough task if headline inflation is still rising at a time when growth is weakening. In this environment, there is the risk that demand for US instruments will falter. There will be the risk that growth will stumble rapidly and this would create expectations that interest rates will be cut quickly again next year. At this point, short-term funds could also abandon the US rapidly.

The most recent global growth indicators have been generally encouraging with rising PMI manufacturing indicators for September and this will boost near-term confidence in stronger activity. The consumer sectors are, however, very stretched in the G7 area as a whole and spending growth is liable to weaken. Given the lead to economic growth supplied by consumer spending over the past five years, it will be very difficult to replace this source of growth. The sharp drop in the US ISM services-sector index for September will also be unsettling.

Confidence is likely to fluctuate between headline inflation and underlying deflation fears in the short term, potentially leading to a sharp fluctuations in sentiment.

Yield advantage could be wiped out

US short-term interest rates are currently yielding 1.75% more than Euros and the bond yields are also offering encouragement to the US currency. The yield on US 10-year bonds is around 1.2% above equivalent German bunds, the highest yield spread for over 6 years. Historically, spreads at these levels have offered dollar support.

In terms of Euro/dollar, however, the short-term yield advantage only equates to just over 2 cents. On a 12-month view, therefore, the dollar would only have to weaken by around 2 cents to wipe out the interest rate advantage. The situation in relation to the Japanese yen and Swiss franc is more advantageous for the US currency given that US yields are 3.0% higher than Swiss rates and close to 3.75% higher than Japanese rates. This yield gap will, however, still not be enough to support the dollar if there is a substantial increase in global risk aversion. Confidence will, therefore, remain vital in the short term and the issue is particularly important given the wide US current account deficits. A steady Wall Street performance will be vital in sustaining confidence.

Liquidity will be an issue

Liquidity levels will remain important and there is likely to be a greater reluctance to take on additional investments where liquidity is in doubt. In this context, the US markets remain in an extremely strong position as the Treasury bond and dollar markets are extremely liquid. If there is a sustained increase in risk aversion, the dollar could benefit in the short term as funds will tend to flow into US Treasuries. The longer-term dollar implications would, however, be more serious for the US markets and dollar given the US current account and budget imbalances.


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