Bond Outlook June 14th

The conventional reason behind raising bank rates is to prevent overheating in the economy and the resultant inflation. Then why are all central banks tightening when there is so much unused industrial capacity and inflation is still moderate? Is it possible that inflation is just an excuse? We suspect so, identifying two other macro-economic issues, frequently mentioned in the Weekly as important but ignored, but which have now quietly moved to the top of the agenda of finance ministers and central bankers:

• The need to reduce trade imbalances, which must necessarily include a reduction in US consumption
• To manage the decline of the USD against other major currencies, given that rises in US interest rates slow the US economy but also strengthen (or slow the long-term decline) of the USD.

The second consideration means that central banks must follow the Fed’s path to tightening, leading to liquidities being reduced and that they will be reduced further. That is precisely what is roiling equity markets.

Unhappy with this effect, many investment houses are criticising Bernanke for being too aggressive in his tightening.