Outlook: Interest Rates

LOW INTEREST rates, it might seem, were a pretty short-lived thing. Just a year ago, rates were tumbling like nine pins across the globe and the word "recession" was on everyone's lips. Now it is the other way round. But for every cloud, there's generally a silver lining and the flip side of the higher short-term interest rate coin is lower long-term rates.

The gilts market reacted enthusiastically to the MPC's announcement of a rate rise yesterday.European bonds were equally buoyed by the ECB's half-point rate rise. Meanwhile across the other side of the Atlantic, US Treasuries too seem to be looking forward with glee to the prospect of another rate rise from the Fed in two weeks' time. In recent weeks, the 30-year benchmark yield has fallen from 6.4 to 6.1 per cent.

In the US, more imminent rate rises are less certain than they are here. The most recent figures show scant sign of domestic inflation in the US as the expansion heads towards the record books for its durability. Even so, if short-term interest rates are going anywhere in the US, it is upwards.

In any event, the result of rising short-term rates in the US, Euroland and the UK, is a revival in the bull market in bonds, and correspondingly lower long-term rates. The same favourable backdrop applies across all three markets.

One factor is shrinking supply, actual or potential. For some time now there has been a budget surplus in the US, the prospect of a surplus in the UK, and narrowing European fiscal deficits. Japan, with its repeated fiscal stimulus packages and ageing population, is the one key exception, and its government bond market has suffered accordingly.

The other main influence has been the inflation outlook. Just over a year ago government bonds, and particularly US Treasuries, were the main beneficiaries of the flight to quality in the wake of Russian default and the near-collapse of Long Term Capital Management. As the fear of world recession has given way to the prospect of a robust recovery, concern about inflation once more came to the fore.

The pick-up in world demand has already had an impact on commodity prices. Until the past couple of weeks, investors' reaction was one of alarm. But the policy response, which the ECB and the Bank of England have been signalling clearly well in advance, has soothed that concern.

Lower long-term rates are the pay-off for early increases in short-term rates. While many might condemn central bankers for being trigger happy on interest rates, the financial markets reward pre-emptive policies. Yesterday's market reaction shows that benign effect in operation. If the markets are right about this, we should be welcoming higher short- term interest rates, not condemning then, for as the bond markets are signalling, a spoonful of medicine now means a good deal less pain later.