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Economics Weekly: How much further could swap rates rise? Weekly economic data preview: Will BoE MPC minutes reveal risk of February rate rise to 5.50%?

Economics Weekly:
How much further could swap rates rise?

In the last few months, swap rates have jumped up, as the underlying bond yields on which their pricing is based have risen sharply. With inflation and short term official interest rates higher, this should not have been a surprise, but the extent of the move has been rapid. A year ago, our models of UK and US 2 year and 5 year swap rates suggested that yields were below fair value by some 40 to 120 basis points; we have updated this model to include the latest data to assess whether these markets are now closer to fair value. Our conclusion is that swap rates could rise further in the next few months but should be lower by the end of the year. The main drivers of the model are consumer price inflation, the relevant underlying bond and three month interbank interest rates. Moreover, there seems to be a systematic bias, i.e. market related trends or trading ranges in the swaps market, so that the past difference between actual and calculated outcome is a good predictor of the current value of swap rates. Our approach takes account of this error correction mechanism.

Swap rates have risen sharply in recent months…
As chart a shows, the rise in yields is not just a UK or US theme, but a global one. We think that despite lower oil prices, fast global economic growth and low real interest rates in the last few years mean that central banks around the world are serious about moving short term official interest rates up to what they see as neutral or normal ranges. However, as they have been doing this, financial markets that have become accustomed to low inflation and low short term interest rates are finding it hard to adjust. For this reason, swap rates seem to be moving only slowly relative to changes in short term official interest rates. Also, it may be that the world still has a lot of liquidity circulating, given that oil exporting countries and emerging markets have been running current account surpluses in the last few years, and this is leading financial markets to become complacent about credit risk and the extent to which short term rates may rise and stay high.

..using assumptions about inflation and interest rates, we predict rates will move higher
Our model suggests that UK and US 2 year swaps will rise further in the next 6 to 12 months. The 5 year swap rate in the UK may reach 6.25% by the end of the year and the 2 year swap rate will approach 6%. The US 5 year swap rate may level off at around 5.60% by June, but it is not yet clear whether short term official US interest rates have peaked or not, and so it may rise even further above this level.

What happens next depends on the assumptions we have made in the model. We have tried using money supply, the shape of the yield curve, retail sales, industrial production and surveys of consumer and business sentiment as explanatory variables in the model, but they are not good predictors of monthly changes in swap rates – though they are useful guides to longer term trends in swap rates. Moreover they are a good guide to the economic background that is in place in the UK and the US. Rapid growth in money supply in the UK, strong PMI surveys and firmer retail and manufacturing data point to an environment of faster economic growth and hence upward pressure on wage inflation. Since UK consumer price inflation is well above the 2% target, at 3% in the year to December, it is clear that short term interest rates are likely to rise further and swap rates may not have priced in all of this risk.

In the US, swap rates seem to be more in line with current economic conditions. However, interest rates in the US have been at 5.25% since November last year and the housing market has recently been showing signs of recovery. Our model suggests that US rates could stay on hold for an extended period following a modest rise in the next few months. However, in the last month, economic indicators from the US have shown robust growth and higher than expected inflation. Should this prove to be sustained, then US official interest rates may yet have to rise further than 5.25%.

Conclusion
In conclusion, our model is suggesting, based on our views for inflation and short term interest rates, that bond yields will rise further and that swap rates will rise alongside them before stabilising towards the end of the year.
Trevor Williams, Chief Economist

Weekly economic data preview

Will BoE MPC minutes reveal risk of February rate rise to 5.50%?


• The minutes of the Bank of England January MPC meeting may clarify if speculation of a rate rise as early as February is justified. We expect the preliminary estimate of Q4 2006 gdp to show that UK economic growth accelerated to 0.8%. BoE governor King is scheduled to give a keynote speech tomorrow in Birmingham.

• A quiet data calendar for the US ahead of the Fed meeting next week features durable goods orders and housing data. Stronger than forecast data for building permits and housing starts last week suggest the housing market may have turned. This is our view but existing and new homes sales data, both due this week, may take longer to confirm that this is the case.

• A rebound in economic sentiment in Germany last week suggests that pessimism over the impact of the VAT increase was unfounded. The German IFO business survey and January CPI data may reinforce the prospect of a 0.25% rise in euro zone interest rates in March.

• The Bank of Japan left interest rates on hold at 0.25% last week, sparking a sharp sell-off in the yen. The Bank reiterated that a further rise in rates would be data dependant. Inflation data will be scrutinised this week and in coming months to see when the Bank is likely to move. Our view is that the Bank was right to wait for further signs of growth and resilient consumer spending.


The minutes of the the January MPC meeting, when the Bank of England decided to raise the cost of borrowing to 5.25%, are due on Wednesday and will dominate the week as we look for more details about the discussion that took place and whether a 0.50% rate increase was discussed. Among the questions that still need answering are: did the Bank vote unanimously to increase rates (we do not think so, Blanchflower may have voted for no change, if we bear in mind his comments in the days prior to the meeting), and did one or more members on the committee propose a 0.50% rate increase? An affirmative answer to the latter would support views that interest rates could rise again in February. The first estimate of UK gdp for the final quarter of 2006 will be released simultaneously with the MPC minutes on Wednesday. A much stronger than forecast 1.1% rise in retail sales in December has, in our view, increased the probability that economic growth accelerated to 0.8% or perhaps even 0.9% last quarter. This would correspond to annual growth of 3.0% and would mark the fastest pace since the second quarter of 2004. This would probably also intensify concerns at the Bank about the level of spare capacity and imply that without further tightening inflation may not fall back to target within two years. This was part of the Bank's rationale for the rate hike earlier this month.

After the data rush of last week, the US calendar and Fed speakers wind down for the two-day Fed FOMC meeting next week. The tone of recent economic data has generally surprised to the upside and proves that economic growth is probably much more resilient than originally thought. The recent strength of services ISM, retail sales and the smaller trade deficit mean economic growth may currently not be far below the 3-3.5% trend range, thus preventing a further decline in core inflation towards 2.0%. Data confirmed this last week when it emerged that core inflation stabilised at 2.6% in December. With the pace of employment growth so far in January hardly showing signs of faltering and the housing market showing signs of stability we feel that risks between the next move in US interest rates being up or down is finely balanced. To this end, markets will concentrate on December durable goods orders on Friday, a proxy of business investment. Existing and new homes sales may bring some confirmation that the housing market is gradually starting to recover from the severe downturn last year.

In the euro zone, markets will concentrate on the release of the German IFO survey on Thursday for the
latest update on conditions in the manufacturing industry. The IFO rose last month to the highest level since records began in 1991. Although we forecast a small pullback, this should not dampen enthusiasm over the country's growth prospects this year. A second consecutive rise for the ZEW survey last week indicated that pessimism over the VAT increase on the economy was probably overdone. German inflation figures for January are due towards the end of the week and may show a rise back above 2.0% due to the VAT rise to 19% on January 1st.
Kenneth Broux, Economist

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15:30 US- EIA Crude
Thu 21 Dec
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13:30 CA- CPI & Retail Sales
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