Interest Rates, The Greenspan Effect

Interest Rates... The Greenspan Effect

At current levels, the euribor and short sterling markets are tough to call, given that they are both being buffeted by conflicting forces. However, following Mr Greenspan’s comments at the end of last week, both markets may well come under short-term pressure in line with eurodollars.

The March eurodollar contract looks set for a test of the 95.50 lows.

The Fed Chairman’s statement that central bank policy is being increasingly driven by asset price changes highlights that he is not only concerned by the potential bubble in the US housing market, but also by the shape of the US yield curve. The refusal of the yield on the 10-year instrument to rise in any meaningful fashion is further underpinning the housing market, insofar as mortgages rates are closely linked to long-term yields. As a result, US rates are likely to keep rising. The risk to this scenario, as we point out in our equity article, is rising oil prices and their effect on US economic activity. Forthcoming data releases are growing in importance.

In the euroland economy, there is far less pressure for interest rates to rise. Ok, so E12 money supply growth in July was extremely strong at 7.9%, which will undoubtedly produce a more hawkish tone by ECB President Trichet at this week’s monetary policy meeting. Yet, the oil price is a risk for Europe too, and in any case the German economic revival appears to stuttering somewhat at the first hurdle, with a positive ZEW number offset by a disappointing IFO reading. That said, in the current climate, we concede that the risk to euribor is on the downside. We are sticking with the technicals though, and as far as the June 2006 contract is concerned, we are only bearish on a break of trendline support at 97.60 (2.40%).

The short sterling outlook is even more confusing. Although UK Q205 real GDP growth was revised up to 0.5%, from 0.4% in Q1, the annual rate of expansion at 1.8% was the weakest in three years. In fact, consumer spending has slowed to its weakest annual pace in more than a decade. Hence the latest reduction in interest rates by the Bank of England, with more hopefully to come. However, although the December 2005 contract held the 95.50 support level to which we alluded a couple of weeks back, the ensuing rally has not materialised. Again, we stick with the technicals. A break of 95.50 would presage a further decline to 95.30 (4.70%). Hard to believe, right? Which is why we favour a push through 95.60, which would open up gains to 95.70. The same problem exists for the June 2006 contract. Failure to break above key resistance at 95.70 suggests a drift back to the 95.55-95.60 area, with major support at 95.45. If the market trades above 95.70 though, it can break higher towards 95.90, which is much more in tune with the fundamental picture of the UK economy.

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