Brace for some policy rigour

PUBLISHED : Sunday, 13 February, 2005, 12:00am
UPDATED : Sunday, 13 February, 2005, 12:00am

Among surprises in the year ahead, brace for fiscal discipline in some unusual places.

United States president George W. Bush could catch global financial markets off guard by getting to grips with the US deficit more firmly than generally expected, according to Kevin Colglazier, head of global fixed interest at First State Investment.

'President Bush may be simplistic but he does tend to tell the public what he is thinking and carry out his policies,' he says.

Last week Mr Bush unveiled what may be the first move towards spending discipline, with a US$2.57 trillion budget, including a rise in spending of 3.5 per cent, that he described as a 'lean budget'.

The deficit is forecast to reach a record US$427 billion this year, but Mr Bush has pledged to cut that to US$233 billion, or 1.5 per cent of GDP in four years.

'Despite any interest-rate increases I believe the performance of the US economy this year will be good but not great - somewhere close to last year's performance,' Mr Colglazier says.

The London-based fund manager cautions the Federal Reserve could also have a few surprises in store in the form of a quickening pace of interest-rate rises. An early warning sign is the growing sense of unease among Fed officials during their December meeting, where talk focused on emerging signs of excessive risk-taking in both financial and real-estate markets.

Mr Colglazier says the Fed's concerns are warranted, judging by narrowing credit spreads, a pick-up in initial public offerings, and an upturn in mergers and acquisition activity. In addition, he says the luxury end of the US real-estate market appears rife with speculative activity.

'I think the Fed has made it fairly clear that they are going to raise interest rates for the next three or four meetings,' he says. 'I would not be surprised to see interest rates at 3 to 3.5 per cent over the course of the year.'

So what effect will rising interest rates, a weak dollar and a massive budget deficit have on the US bond market? Probably very little, Mr Colglazier says, adding that wary investors will take refuge in bonds.

Foreign central banks, especially those in Asia with massive treasury holdings, are unlikely to dump any time soon.

'Historically a weak dollar has little impact on the bond market,' he says.

'The size of the bond holdings these banks have amassed makes it difficult to sell in large volumes and I think this is extremely unlikely.'

Despite a doubling of core inflation and chronic dollar depreciation, the 10-year treasury bond yields essentially ended last year where they started - floating around the 4.2 per cent mark.

Mr Colglazier predicts the next 12 months could hold something similar in store, with bond market yields likely to trade about the same level as now.

Last year his bond-market forecasts were correct overall, with the 10-year note hovering between 3.9 and 4.4 per cent for most of the year.