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Equities and bonds bounce back

RENEWED optimism of a US recovery, fuelled by a change in attitude from US Federal Reserve chairman Alan Greenspan, resulted in steady incremental growth in equites and bond yields over the past week.

But it was not just Dr Greenspan’s more optimistic assessment of the US economy – just two weeks after he talked down the economy – that changed local market sentiment.

The higher-than-expected December quarter Australian Consumer Price Index also was a factor that pushed interest rates across the yield curve.

Yields on benchmark 10-year Commonwealth bonds have now risen a full percentage point since briefly slumping below 5 per cent just before the fall of Kabul in Afghanistan.

Last week, the local 10-year bond yield rose to 5.96 per cent from 5.69 per cent a week earlier, while March bank bill futures’ implied yield rose to 4.31 per cent from 4.13 a week earlier.

Writing on the latest inflation figures in his January economic review, BankWest economist Alan Langford noted that actual and expected inflation was the number one enemy of investors in longer dated bonds. Conversely, the short to middle part of the yield curve was being hammered by expectations that the Reserve Bank would soon start looking to the tightening of monetary policy.

“There is no doubt that the December quarter inflation figure was a touch high for comfort, because underlying (or core) measures of inflation have not only breached the top of the RBA’s 2-3 per cent medium-term target range, but are much closer to 3.5 per cent than 3 per cent,” Mr Langford said.

But the strong inflation figures are unlikely to be met with a swift response to increase rates from the RBA when it meets next week.

While businesses have been increasing margins over the past quarter, their ability to continue to do so next quarter may be under question if the Japanese and US economies sink deeper into recession and share deflationary, not inflationary, concerns.

Housing construction activity, the key driver of the Australian economy besides exports, also looks set to plateau by mid year, leaving consumption and business investment to fill the gap.

Consumer spending and sentiment continues to gain ground, although threatened by soft labour markets, while business investment also is showing signs of recovering from a two-year decline.

Westpac general manager economics Bill Evans still sees further rate cuts as a real possibility, given the fall in housing investment.

“The concern for the monetary authorities will be that, with housing unlikely to be continuing to provide the growth boost of recent times, exports slowing in response to the global recession and consumer spending possibly reacting to a soft labour market, what is going to fill the ‘growth hole’ by the middle of the year,” Mr Evans said.

“On balance, we remain sceptical about the timing and strength of the US recovery and do expect the ‘growth hole’ to emerge in Australia. That will eliminate any pressure for rate increases for some time to come and could lead to a final ‘insurance ease’.”

But while the CPI figures have brought the attention of investors back to local economic data, it will be the US economy that will set Australia’s and the RBA’s real agenda in 2002.

“If the US economy does pull out of recession by the second quarter, and if Japan is at least showing signs of life, the RBA may consider ‘snugging’ the cash rate modestly higher by the end of this year, to push it back up to a neutral level,” Mr Langford said.

“In the context of the likely persistence of downside risks to global economic growth for some time yet, and the absence of global inflationary pressures, the neutral cash rate at the moment almost certainly is not more than 5 per cent.

“Despite the rate of acceleration in underlying inflation in the December quarter, an unchanged cash rate from the rest of 2002 remains the most likely scenario (although there was probably enough in the CPI to factor an increase late in the year as the most likely scenario).

“Bank bill and shorter dated bond yields are likely to trade erratically, however, as markets jump at shadows in reaction to even the most subtle actual and perceived changes of tone in central bank statement (both official and informal).”

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