All eyes on interest rates around the world

Buoyant stock markets continue to climb higher. The Euro Stoxx-50 is up 17% so far this year-to-date.

All eyes on interest rates around the world

Buoyant stock markets continue to climb higher. The Euro Stoxx-50 is up 17% so far this year-to-date.

The S&P 500 is up over 20%, hitting record highs, with the index breaching the 3,000 level last week.

Indeed, the S&P has posted its best first half of the year performance since 1997. Bond markets have also rallied strongly this year.

The fuel for the big gains in markets is being provided by signals coming from central banks, who look to be lining up to cut interest rates.

The Reserve Bank of Australia has already cut rates by 25 basis points twice in the past two months, with the Bank of India also lowering rates recently.

The market expects the Fed to cut rates by 25 basis points later this month, with close to 100 basis points in total easing being priced in for the coming year.

The ECB is expected to cut rates by 15 basis points in the months ahead, which would bring its key deposit rate down to -0.55%.

It is also likely to restart its quantitative easing - or QE - bond purchase programme. Meanwhile, close to a 25bps rate cut by the Bank of England is being priced in for early next year.

Global economic activity has lost momentum in the past year, though much of the weakness is concentrated in manufacturing.

This has coincided with a very sharp slowdown in international trade, with the US involved in multiple trade rows most notably with China.

Central banks have been busy highlighting the downside risks to global growth in recent times and the need to take action.

The policy easing is expected to continue into next year and markets do not foresee rate cuts being taken back anytime soon after that.

However, the big rally in both equity and bond markets this year represents a substantial easing of monetary conditions, which should support growth going forward.

Meanwhile, the unemployment rates in the US and UK have declined to below 4%, their lowest levels in nearly 50 years.

The jobless rate in the eurozone has fallen to 7.5%, close to multi-decade lows also.

Wage growth is picking up as labour markets tighten.

Consumer spending is being supported by continuing solid employment growth and rising real household incomes.

Many services industries continue to perform well, most notably in the eurozone.

If growth does improve over the next year, then central banks may not deliver all the policy easing expected by markets and/or could unwind rate cuts rather quickly.

Indeed, bond yields have backed up over the past week, with 10-year yields rising by 15-20 basis points in the US, eurozone and UK.

This has been largely due to a run of stronger than expected US data, in particular the June employment report that saw non-farm payrolls rise by 224,000.

On top of this, core inflation registered its biggest jump in June in nearly a year and a half, with the index rising by 0.3%, pushing the annual rate to 2.1%.

These data won’t stop central banks easing policy in the next couple of months.

However, the scale and duration of policy easing over the coming year may not match market expectations.

The rise in bond yields in the past week suggests that traders may be having second thoughts about the extent of central bank easing and, in particular, if the Fed will follow a July rate reduction, with a string of further rate cuts stretching into next year.

Disappointment on this front would most likely signal the end of the very strong rally we have seen in financial markets this year and, indeed, could send some markets into reverse.

Oliver Mangan is chief economist at AIB

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