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Rising interest rates go global
The European Central Bank will likely hike interest rates repeatedly in 2006, and even the Bank of Japan will actually raise them a bit. Here's what that means for the global economy and your wallet.
By Jim Jubak
I think 2006 is likely to be a year when the direction of the global economies and financial markets are set, not by a single bank (as they were in 2005 by the U.S. Federal Reserve), but by the interaction of policy at the U.S. Fed, the Bank of Japan and the European Central Bank.
The more moving parts in any machine -- even a virtual financial machine -- the greater the chance of a breakdown, of course. And the greater the chance that a slight malfunction in one part will cause unexpected and erratic performance by the machine as a whole. In other words, whether you liked departed Federal Reserve chairman Alan Greenspan or not, a 2005 dominated by the U.S. Federal Reserve was more predictable than 2006 is likely to be.
The U.S. Federal Reserve succeeded in hogging the interest-rate headlines in 2005. Raising interest rates 14 times for the world's largest economy does tend to send the spotlight in your direction. Add in the excitement of Alan Greenspan's departure as Federal Reserve chairman and speculation about whether or not incoming chairman Ben Bernanke is up to the job, and you've got media coverage that even Mariah Carey might envy.
Head of the class
In 2005, the Federal Reserve's activity held center stage so easily because the world's other major central banks -- especially the Bank of Japan and the European Central Bank -- did so little.
What were the world's two other big-name central banks doing while the U.S. Federal Reserve was raising short-term interest rates to 4.5% at its Jan. 31 meeting?
The Bank of Japan, of course, was doing nothing -- as it has done, year in and year out, since it set short-term interest rates in Japan at 0%. On Monday, the official discount rate (the rate the Bank of Japan charges member banks for loans) stood at 0.1%, exactly where it has been since Sept. 19, 2001.
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The European Central Bank was a comparative dynamo in 2005. After keeping short-term interest rates at 2% for five years, the central bank for the European Union raised rates to 2.25% in December 2005.
So for 2005, the story in the financial markets was the growing gap between interest rates set by the Federal Reserve and interest rates in Japan and Europe. At the beginning of 2005, the difference between the Fed's short-term rate for the United States at 2.25% and short-term rates in Japan at 0% was 2.25 percentage points. By the end of last month, the gap had widened to 4.5 percentage points. In the case of the European Union, the gap in rates grew from a mere 0.25 percentage points at the beginning of 2005 to a relatively major gap of 2.25 percentage points.
The conundrum, explained
No wonder that in 2005, the United States had no trouble getting overseas investors to cover a record trade deficit of more than $700 billion, more than $80 billion larger than 2004's record. Energy prices, government budget deficits, consumer indebtedness -- none of that mattered in the final analysis. Overseas investors saw that huge edge in yield that they'd get by "Buying American," and they bought. As a consequence, the U.S. dollar stayed strong, surprising just about everyone (myself included). And because the dollar was steady -- or better -- for much of the year, overseas investors flocked to buy long-term U.S. notes and bonds, in order to lock in comparatively high U.S. interest rates for the long haul.
So, much to the surprise of Alan Greenspan, U.S. long-term interest rates actually declined as short-term rates climbed.
So far, at least, 2006 looks like it will be much different. The European Central Bank seems determined to hike rates repeatedly in 2006, with the next increase projected for March. And, amazingly enough, it's likely that the Bank of Japan will actually raise interest rates this year -- although not by very much.
We're not talking about a quick closing of the yield gap in 2006, however. European economies are just not that strong. Economists polled by The Economist magazine indeed do expect the economies of the euro-zone to grow at a faster rate in 2006 than in 2005. But the pickup is exceedingly modest: to 1.9% growth in 2006 from 1.4% growth in 2005. The Germany economy is projected to show the biggest improvement, with growth swinging to 1.7% in 2006 from 1.1% in 2005. But France (at a projected 1.9% growth rate in 2006) and Italy (at 2.1% in 2006) have major budget and unemployment problems that would lead to loud and probably violent protests against multiple interest-rate increases.
The combination of 2% economic growth (and especially the big improvement in the Germany economy) with 5% to 10% appreciation in the euro against the dollar could lead the European equity markets to outperform U.S. equity markets again in 2006. In 2005, the German DAX index ($US:DAX) returned 16.2% to the 3% return of the U.S. Standard & Poor's 500 ($INX) stock index. That followed similar outperformance in 2004 when the DAX returned 15.4% to the S&P 500's 9%.
Rate increases in Japan are likely to have strikingly different effects because 1) they start from such a low interest-rate base, and 2) the Japanese financial system is so close to a crisis brought on by the country's rapidly aging population.
Only in a country battered so badly and for so long would the 0.3% growth in GDP projected for 2006 be greeted with such joy. But because the country has been traumatized by its long-running economic slump, the Bank of Japan faces a huge uphill political battle to raise rates even a token 0.25 percentage points. No politician in Japan wants to run the risk of prematurely shutting down the current economic recovery and restarting the deflationary spiral that has kept Japan down for so long. Each time the Bank of Japan has even breathed the possibility of a rate increase, the government has lashed back hard, pointing out that growth is still extremely fragile.
Too little, too soon
The consensus among analysts who follow the Japanese markets is that any rate increase is extremely unlikely before the end of the country's fiscal year on March 31. It's too close to the year-end financial reports to rock the boat so radically. My opinion is that the timing of the move will depend on how fast inflation shows up in Japan. But no matter what the timing, I don't think we're looking at more than one or two 0.25 percentage point moves in 2006.
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