Go-it-alone bonds take US rates in their stride

It's easy to find European bond investors who believe the US Federal Reserve will raise interest rates on Tuesday. But it's rather difficult to find any who are worried about it.

Long before a US rate increase was taken for granted, investors realised European economies were marching to a different drum. So if the US central bank raises the federal funds rate to 5.5 per cent, as expected, European bonds will suffer - at most - only a temporary setback.

"I don't think a US rate rise will make much difference to the US markets, let alone Europe," said Julian Jessop, an economist at Nikko Europe. "Most people understand that the economic situation here is different."

The key difference between the US and Europe, of course, is that much of the region is still suffering from patchy growth, which has kept inflation at low levels for the past one- and-a-half years. By pegging their currencies to the mark, Europe's central banks have watched annual inflation rates drop to between 1 and 2.5 per cent.

In addition, the economies of EU countries are constrained by tough budget- cutting requirements as part of the run-up to the single currency. Some, like Germany and France, are also struggling with record unemployment, which is stifling growth.

In the US, on the other hand, the Fed faces an economy with unemployment down to 5.3 per cent, gross domestic product growing at an annual rate of 4.7 per cent and consumer prices rising at annual rate of 3 per cent.

While that is not in itself an inflationary picture, Alan Greenspan, the Fed's head, has seen the need to move ahead of the curve to check inflation before it starts.

What's more, Europe has not always taken its interest rate cues from the Fed. In 1994, when the US central bank increased its target money market rate to 5.5 per cent from 3 per cent, the Bundesbank had no qualms about cutting its securities repurchase rate to 4.86 per cent from 6 per cent.

European economies not only have less and less in common with the US. They also have more in common with one another - specifically, the drive to get economies into shape for the common currency. That drive has pushed nations' currency, interest rate and budget policies closer together.

That's true even in the UK, which reserves the right to opt out of the single currency. Britain looks as if it has more in common with the US. Its economic growth has been outstripping its European neighbours, and its monetary authorities have raised base rates a quarter of a percentage point to ward off inflation.

Even so, analysts said, a US rate rise won't have much effect on gilts, if only because the Treasury pays more attention to the continent when comparing inflation rates.

This year, what most European central banks would like to do is leave things alone. The Bundesbank says it did enough to generate economic growth by easing rates to record lows last year. It also sees "no need", according to Hans Tietmeyer, the bank's president, to raise rates in the "coming weeks or months".

Of course, higher US rates could strengthen the dollar, raising the price of imports for Europeans and eventually the rate of inflation. But so far, that hasn't happened. The dollar is up 10 per cent against the mark since the start of the year, yet Germany's CPI rose at an annual rate of just 1.8 per cent last month.

Bonds in Europe are also paying less attention to shifts in US Treasuries. German bonds, the European bellwether, currently yield 1 percentage point less than comparable US bonds, the widest yield gap in favour of bonds in more than seven years. Bonds in France, the Netherlands, Denmark and Ireland also yield less than Treasuries, reflecting investor preference for Europe's low inflation. Copyright: IOS & Bloomberg