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Global centres of growth move away from West: NBD

DUBAI — In the eleven months since the US Federal Reserve Board first started raising the Fed Funds rate the yield curve has flattened significantly with the 10 by 2-Year swap spread trading as low as 33 basis points in the recent past according to a recent report by the National Bank of Dubai (NBD). The real question is: Are we facing growth, stagflation or recession in the future? (Traditionally a flattening yield curve has been associated with a slowing economy).

The current flattening yield curve is nothing but a manifestation of a shift in the 'Centres of Growth' away from the traditional western economies. As Asian economies continue to grow there is an increase in their currency reserves both on account of higher investment into these economies as well as increasing exports. As a result, Asian currencies have been experiencing pressures to appreciate, which have been stalled by respective central banks by mopping up excess US Dollars and building up their foreign currency reserves.

The Central banks have parked these reserves in traditional "safe-investments", primarily the US treasuries and driven down the long end of the yield curve. This signals that the markets are acknowledging the growth differential between the US and other first world economies. In effect this action has also funded US consumption, as the fiscal deficit in the US (at 6.4 per cent of GDP in the first quarter this year) continues to be met by issuing treasury notes for which there seems to be large appetite. Although long thought to be unviable, this cycle has so far worked, with the US consumption in return fuelling growth in the Asian economies.

GDP forecast for the US for the 2005 is at 3.5 per cent, Japan at 1.9 per cent and for the Eurozone at around 1.4 per cent. As a result, global GDP gap between the US and other developed economies has risen.

An increasing output gap has further added strength to investor confidence in the US and is likely to continue boosting investments in both US bond and stock markets.

In the May FOMC meeting, the Fed raised the Fed rate by 25 bps to 3.0 per cent, on the strength of growing productivity. Although short term inflation lowered consumer spending (on account of higher energy prices) long term inflation was expected to be contained. The Fed is expected to raise rates by another 25 bps in the June FOMC. The ECB and BOE left rates unchanged in Q2 2005 as expected.

The ECB is expected to continue to hold rates steady while BOE on the other hand did cut rates recently as consumer spending, in England is slowing down.

CURRENCIES

Stronger growth in the US relative to the rest of the world and the possibility of more Federal Reserve interest rate hikes will continue to underpin the dollar in the intermediate term. However, in the short run the technical backdrop indicates some consolidation ahead. The Federal Reserve has not backed away from raising interest rates, although the tightening cycle may be in its late stages.

The deceleration in the global economy also implies that interest rates will be cut in several regions in the world, which will underpin the US dollar. The euro may see lows of 1.1950 before bouncing back. Investment flows point to a weaker euro. The Euro broke key levels of 1.2750, and suffered further with the negative outcome of the referendum on the adoption of the EU constitution in France and the Netherlands. Euro area investors have begun to move back into US stocks. Euro area purchases of US corporate and government bonds have also surged in the recent past. Yen is however likely to see an overall strengthening trend against the US Dollar on account of an expected Yuan appreciation.

EQUITIES

World equity markets have remained generally neutral to modestly negative during the quarter. The DowJones and S&P were down 2.43 per cent and 0.16 per cent respectively over the laset quarter, whereas the Nasdaq was up 1.05 per cent. The Nikkei 225 also fell by 5.2 per cent, whereas the European stock markets were largely positive, with the DAX growing by 5.17 per cent and Eurostoxx 50 by 2.73 per cent. Going forward US markets are likely to benefit from the positive investor confidence. Corporate results have held despite oil prices being high, and rates being hiked successively.

Recent economic indicators also point towards a positive growth story in the US, and the equity markets are likely to cash in on this feel good factor.

COMMODITIES

The CRB index of 17 commodities was 15.0 per cent up Year on Year in June 2005. In particular, Copper prices rose to a 16-year high in June, up 34 per cent (Year on Year), as inventories dropped. Expectations of slackening Chinese demand were proved wrong as demand rose for metals, as Chinese Industrial production rose 17.0 per cent and China's fixed asset investments rose 28.0 per cent in the second quarter.