THE MARKET is not supposed to get things wrong. But most analysts are deeply suspicious about the signals it is sending on the likely course of interest rates next year. Take a look at what are known as Fed Funds futures contracts - which indicate where the market believes the United States Fed Funds rate will be at a designated point in the future. The target rate set by the US central bank is at a 30-year low of 2 per cent and the expectation is it will be cut by another 25 basis points in New York overnight, to just 1.75 per cent. Analysts are less certain about what happens next but most believe this will be followed by another 25-basis-point cut to 1.50 per cent at the Fed's next meeting on January 29. But the June Fed Funds futures' contract is trading at 1.98 per cent - indicating the view the Fed would by then have begun a reasonably aggressive tightening of interest rates to choke off what the market expects will be an inflationary spiral triggered by strong economic recovery. The same expectations lie behind a big bounce in US 10-year treasury yields, which have jumped to 5.14 per cent, from just 4.18 per cent at the beginning of last month. That is a sign of investors selling their fixed-interest portfolios and bidding prices down and yields up in the process - to 'lock in' gains before interest rates begin rising again and thus reduce the value of their investments. And the same is true of eurodollar futures, with the 2002 December eurodollar rate at about 4 per cent, versus a spot rate of just 2 per cent. All of this signals a 'very strong' rebound in interest rates after the first or second quarter of next year, said Eric Cheung, senior vice-president (treasury) for DBS Group in Hong Kong. What the market was indicating was that the US economic recovery would be V-shaped, which implies a rise in inflation, and hence an aggressive pre-emptive move by the Fed to raise rates to nip it in the bud. But Mr Cheung - along with several other analysts - disagreed. 'It is too early to judge with certainty,' he said. 'But I believe the recovery is more likely to be U-shaped or even L-shaped, and rates will stay low for much longer than the market is presently signalling.' Mr Cheung believed the average for the Fed Funds rate next year was likely to be only about 2.5 per cent. Citic Ka Wa bank senior vice-president and treasurer Moses Yeung agreed, saying the selling of US Treasuries by Fund Managers appeared to have been overdone. 'I don't agree. But you can't argue with the market,' he said, and corporate treasurers would be well advised to hedge their interest rate risks in this confused market. So why has the market read the tea leaves wrong? Mr Yeung said he accepted the US economic engine drove the global economy and in turn was driven mainly by four factors - US capital spending, employment, corporate earnings and consumer spending. The indications on the capital front were favourable, Mr Yeung said. The US manufacturing sector had worked through its overstocked situation and brought inventories and capacity back in line with demand. As for public expenditure, the campaign to reflate the economy was under way. 'But the other three factors remain unclear,' Mr Yeung said. 'Only a few IT companies have signalled improved earnings growth, but the market is already pricing in double-digit corporate earnings growth. I am not so sure.' In the absence of improved earnings, companies could continue laying-off staff, which means higher unemployment and lower consumer spending. Against this background, Hong Kong could be in for 'interesting times' next year, Mr Yeung said. Were the Fed to make another 25-basis-point cut next month, local rates would have to move. 'But no bank can afford zero savings rates - it is just a public relations issue,' Mr Yeung said. That means lending rates will fall, but deposit rates will not match those falls - which means the banks' interest margins will come under pressure. Desmond Supple, head of Asian research for Barclays Capital, said he believed a decline in inflation in the US would allow the Fed to err on the side of caution and cut by another 25 basis points this week. But he also believed it could be the last and though he agreed with the market signals that a tightening of rates could be under way by the second half of the year, he was less certain about the extent of that tightening. He said the market appeared to have priced in a more aggressive tightening than was likely to emerge. 'The market is suggesting that the US economy is off to the races,' said Mr Supple. He was referring to the full percentage point increase in US Treasuries. 'The pace of the tightening it is expecting does look a little optimistic, but growth expectations are only part of the story and the other reason for the sell-off would be the liquidity. 'It is a little excessive and I don't believe the inflation dynamics justify such an aggressive shift.' JP Morgan credit analyst Amy Li said there was a 'huge dichotomy' in economic data emanating from the US. 'They show very strong durable spending - mainly on [vehicle] sales - but worsening unemployment numbers. So we don't know which force will finally prevail,' Ms Li said. While a consensus was emerging on the likelihood of economic recovery in the first half of next year - for both the US and Hong Kong - a number of factors complicated this view, she said. 'The obvious one is the war in Afghanistan and its repercussions - and even when that has ended there is likely to be a delay until the economy grows at a pace faster than its growth potential,' Ms Li said. 'Not until that happens will we see rates go back up.' Another sceptic was Paul Tang, Bank of East Asia chief economist. 'Just look at the 12-month Libor [London interbank offered rate],' he said. 'It is of course quite volatile, but is now at 2.59 per cent compared with 2.04 per cent for one-month. 'That is a 55 basis-point spread - which has already taken into account the 25 basis point cut to rates expected this week. 'This reflects market concern that once the US recovery gets under way, rates will rise very quickly - at least 50 basis points to 100 basis points within six months of the recovery starting.' However, that was not necessarily bad news for Hong Kong, Mr Tang said. The downside of rising interest rates would be more than compensated for by increased activity in the US economy.