Interest rate rises and rapid growth loom

By Neville Bennett

Friday 14th May 2004

Global equities are in a state of rout. The Dow Jones Industrial Average gave up the 10,000 level with hardly a struggle.

Other things are happening in the market that are worth emphasis.

One unusual phenomenon is that gold is going down and oil has appreciated; they normally act in loose association. So what is driving the market?

March was decisive. Until about March 20, there was a bull market in equities, driven by good earnings, increasing employment and consumer spending.

The S&P500 chart shows a nice upward curve from May 2003 to March 2004, when the S&P rose steadily from 900 to 1160.

There was a shock, around March 20 (the train bombings in Spain), but equities recovered to stabilise around 1140. Another selloff occurred on April 12.

Obviously there was a deep earthquake in the financial world, although most observers thought nothing untoward was happening. But the best financial seismograph is always the bond futures market, for the bond market is where the real money is.

The market turned from a rising capital trend to a steeply falling one on March 21. Huge sums had gone into the market, driving up the 30-year bond to $115; within weeks it had gone down to $106.

Vast numbers of bond holders were taking a 10% loss of capital and bonds are supposed to be secure.

The selloff in the bond market was mirrored in the gold market.

Oil wavered for a day or so but then recovered its forward march. The selloff was because the market had suddenly become aware of an interest rate rise. The Federal Reserve made no changes but it was expected to.

The gold selloff was only partly affected by rising interest-rate concerns. Some investors go short on gold when rates rise because of the opportunity cost of holding it.

Equally, other investors take a contrary view and buy gold as a store of value in inflationary times. Gold is therefore hard to pigeon-hole.

Currency is another influence.

As a general rule, when US interest rates rise (or seem about to) foreign investors are attracted to US bonds. They buy US currency, increasing the dollar's relative price.

A higher dollar weakens gold's role as a hedge against currency depreciation, so it loses value quickly.

Gold is extremely volatile.

As a way of understanding the market better, I spent some time on Saturday looking at trades in gold futures on Friday, May 7.

The market opened in Tokyo with only 20,000 contracts. Sydney, Singapore and Dubai were active. London sold 60,000 contracts, New York 250,000.

Gold had lost a few dollars but a huge trade had occurred. If gold is $400 an ounce and a single contract equals 100oz, about $US150 million entered the market.

The physical market is also big and gold equities have been one of the biggest losers since March. A good example is Newmont, the biggest miner of all. In Australia it had gone up to $A6.50. It is now about $A5.20. Some gold equities have halved.

Silver has suffered a holocaust.

US bank shares have also suffered: the US Bank Index (BKX) fell from 103 to 98 in a day, hesitated and has since slid to 95. This means a loss of 7-8% on a bank portfolio. Banks suffer when rates rise because lending falls, reducing the size of their loan portfolio.

Oil also suffered briefly but marched on toward $US40 a barrel. Market commentators always ascribe its rise to political factors, especially Iraq, but there is an economic rationale: as the world economy improves, which is what rising interest rates are signalling, the demand for energy is rising.

Oil is on an all time high and natural gas not far off. But petrol costs are hurting consumers and worrying Wall Street.

The shock appears to have come from the CPI index, which showed a 0.5% increase in one month and the prospect of a 5% annual rate.

The market saw a turning point. It became of matter of when the Fed would raise rates and by how much. It accepts a series of "measured" raises.

The prospect of a rising interest rate environment should not have spooked the market. It would take a lot of measured 0.25% raises to get away from the present 1-3.5%, which economists believe is "neutral." Moreover, experience shows very mild inflation is quite good for business and that some aggressive raising is compatible with a bull market as happened in 1994.

But Wall Street is slipping, fearing the combination of high fuel and interest prices. There is no rational reason for equities to slip further as new money is flooding in for funds, profits are excellent and the consumer is active.

Until the market gets a sense of how fast the Fed will raise rates, however, it will be hard for the market to advance consistently. One expects a relief rally when Fed chairman Alan Greenspan does act.

Wall Street is uncertain, but in retreat.

It is a period of transition as investors are changing their expectations and adjusting to the certainty of interest rates rises and rapid global growth.

Eventually the market will perceive that mild inflation is good for business.

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