US Federal Reserve
Get more with myNEWS
A personalised news feed of stories that matter to you
Learn more

Robust market may be living on its nerves for a while yet

The Hang Seng Index has had a storming start to the year. In just over four months, the index has gained 14 per cent, more than it did in either last year or 2004. If it carries on rising at this pace, the Hong Kong stock market will have its best year since the crisis rebound and technology boom of 1999.

But, that is a big 'if'. For all its vigour, this is a nervous market. Throughout the year so far, successive run-ups have coincided with mounting expectations that the current cycle of interest rate increases is nearing its peak. Then, every time the market hits a new high, fears resurface that rates may still have further to rise and the index slips back again.

Last week, the bulls were back. On Wednesday, the index climbed to a new 5?-year high above 17,000 points, propelled partly by fresh hopes that the rate rises were nearly over. Once again, they may prove premature.

This Wednesday, the US Federal Open Market Committee assembles for its third meeting of the year. The gathering will be almost as closely watched in Hong Kong as on Wall Street. Because of Hong Kong's pegged exchange rate, our interest rates closely mirror those in the United States. Where the Fed leads, we follow.

This time around, the vast majority of market players expect the committee, headed by new Federal Reserve chairman Ben Bernanke, to raise the benchmark short-term US interest rate by 0.25 of a percentage point to 5 per cent. After that, they think the Fed will stop, holding steady at its meetings next month and in August and possibly even cutting rates later in the year if the US housing market softens.

That would be good news for the Hong Kong stock market, especially for the territory's banking stocks, which have lagged the overall market this year, held back by worries higher rates will eat into their lending business.

There are some good reasons to believe the Fed may follow this path. Testifying before the US Congress last month, Mr Bernanke said 'at some point in the future, the committee may decide to take no action'. Most on Wall Street saw this as a clear hint the Fed was ready to stop the raises. 'US rates have almost reached neutrality,' explains John Greenwood, chief economist at asset management firm Invesco. With short-term rates at 5 per cent, they will be in line with US GDP growth, which is roughly where they should be, he says.

But there are indications the Fed is not done yet. Although the Fed has no specific inflation target, it is known that Mr Bernanke favours keeping core inflation - less food and energy - within a 1 per cent to 2 per cent comfort zone (see chart). With the core rate just breaching the ceiling of that band in March, crude oil trading above US$70 a barrel and threatening to stoke further price rises and labour costs in the US accelerating, it is possible the Fed may decide on preemptive action to contain inflation.

That would mean more rises. At the moment, however, the outlook is still hazy, which may prompt the Fed to hold rates steady next month pending more conclusive data. If it then looks like inflation is picking up, the Fed could resume raising rates at subsequent meetings. Mr Bernanke himself stressed this possibility before Congress, although that part of his message went largely ignored.

Some in the financial markets still think of Mr Bernanke as 'Helicopter Ben', recalling his 2002 suggestion that the Fed drop money from a helicopter in a crisis. Back then, however, he was talking about fighting deflation. Now, with prices rising, he may prove a far meaner inflation hawk than they expect.

'We will see an aggressive response if core inflation rises,' says Bruce Kasman, chief economist at JP Morgan. He says the Fed may well pause in June but will then go on to push short-term interest rates up to 6 per cent by the end of next year.

If he is right, the Hang Seng Index is in for a volatile ride. If the Fed holds steady next month, it could trigger another sharp rally. If it then raises rates, stocks may suffer. The market may be living on its nerves for a while yet.