US, European rates seen rising this year

LONDON - Interest rates in the United States and the euro zone are set to rise twice during 2006, as the Fed brings its rate cycle to an end and the European Central Bank tightens cautiously for fear of choking the economy.

A December 14-20 Reuters poll of 36 bond strategists also showed the Bank of Japan raising its key rate fractionally above current levels of virtually zero late next year, and forecast one rate cut in Britain by the end of June.

Median forecasts showed US interest rates peaking at 4.75 per cent in the second quarter, after a steady tightening cycle which has so far added 325 basis points to the cost of borrowing from 1.00 per cent in June 2004.

"We think around 4.5 per cent is the adequate level for US interest rates -- you could call it a neutral level -- and as there are modest inflation risks in the U.S., we expect the Fed to go slightly beyond that to 4.75," said Holger Schmieding at Bank of America in London.

US fed funds overtook the euro zone's key refi rate a year ago and the spread between the two has steadily widened. But signs of a long-awaited pick up in business and consumer activity in the euro zone finally enabled the European Central Bank to start hiking this month with a move to 2.25 per cent.

The survey pointed to two more ECB hikes in 2006, signaling that the rates differential with the United States will stay broadly stable, supporting the euro and pushing up government bond yields in the 12-nation bloc.

"Growth prospects have brightened ... Against this background and due to the excess liquidity in the euro zone, which is a threat for price stability, the ECB will hike interest rates in 2006 to 2.75 per cent," said Gernot Griebling at LBBW in Stuttgart.

But with the medians in the poll showing a rate hike by end March and one more in the second half of the year, the pace of tightening in the euro zone is expected to remain very gentle, so as not to upset the economic recovery.

Japan, Britain

In Japan, rate hikes -- when they eventually start -- will probably come in even smaller steps. There are signs that the Bank of Japan's ultra-loose monetary policy has finally paid off in the shape of better growth and, perhaps as early as the current quarter, an end to deflation.

The first step would be for the BOJ to end its policy of flooding the banking system with cash. Rate hikes may then follow, but only very cautiously -- the median in the survey showed the overnight call rate edging up only very marginally by the end of 2006 to 0.10 per cent.

By contrast, the Bank of England was the first major central bank to start the tightening cycle back in November 2003. This August, concerns about slowing growth and the risk of a housing market crash prompted it to cut rates to 4.50 per cent.

The majority in the poll expect at least one more rate cut during the course of next year, though a sizeable minority say an improvement in growth and concerns about the longer term inflation outlook could instead result in a rate hike.

The medians showed the US fed funds rate matching Britain's repo rate in the first quarter and overtaking it for the first time in five years by mid-year.

But while a timely rate cut seems to have averted a possible housing market crash in Britain for now, in the United States, house prices remain a key risk.

"The risk for the US is that the housing market there may slow markedly, so you can actually argue that for once the UK is actually leading the U.S.," said James Knightley at ING Financial Markets in London.

ING was one of the 10 contributors to the survey who expected US rates to be cut toward the end of next year.

End-2006 fed funds forecasts ranged from 3.5 to 5.5 per cent. For Britain the range was 3.5 to 4.75 per cent, for the euro zone 2.5 to 3.5 per cent and for Japan 0.00 per cent to 0.40.

- REUTERS