The interest rate story is not over yet…

The US 10-year treasury yield is quietly heading towards 5.0%, unmindful of surging prices of crude oil and base metals. Fixed income investors have assumed inflation to be irrelevant, and growth to be history. They are toying with the notion that the consumer is hurt by the high price of oil and the faltering housing market and hence, would begin to save more and spend less, sending the US economy into recession and that the Fed would be cutting rates before long. Interest rate futures contracts show a marked reluctance to price in a Federal funds rate of above 5.5%, at most. Even that is not fully in the price.

In contrast, financial markets are willing to assume that rates everywhere else would go up significantly. Interest rate futures show that market participants expect another 50 basis points increase in Australia, in the UK and more than 125 basis points in the Eurozone. This means that market participants either anticipate worsening inflation or stronger growth or a combination of the two in these economies but not in the US.

They may be mistaken on two counts. One is that their pessimism on US growth may turn out to be misplaced. Two, if this pessimism was well founded, then certainly, their optimism on other economies would be misplaced. Even an experienced market observer like Ned Davis of Ned Davis research, in a recent interview with Barron?s, focuses on high levels of private sector debt and troubles in the housing market as reasons for his pessimism. These concerns focus on the US consumer?s liabilities, but not his assets. It is equally true that total networth and household assets have gone well past the peak of 2000. In other words, the real balance sheet position of the US consumer is not as dire as is generally construed.

Let us also look at the evidence from another angle. How many of us honestly thought that the US consumer would be able to handle a Fed rate of 5.25% and with oil price at above $75 per barrel? I, for one, did not think back in 2003 that given the so-called debt levels, the US economy would be able to handle any rate level above 3%. I have been wrong.

In fact, there is reason to wonder if US official statistics are understating real growth, if one goes by the steep rise in the US government revenues. The fiscal deficit is set to come in around just 2.3% of GDP for the fiscal year ending 2005-06. If revenues are rising far in excess of the real economy growth rate, then one wonders whether there is any under-measurement of the latter. In the past, there has been close alignment of the growth rate of the economy with that of the growth rate of the tax revenues. In cidentally, with the main Eurozone countries struggling to reach a budget deficit of 3% of GDP and given their longer term demographic problems, one wonders about the structural case for EUR strength against the USD.

Second, Dennis Gartman of The Gartman Letter (TGL), in a recent newsletter, cogently argued that the household survey is doing a far better job of measuring employment growth than the survey of business establishments, as the former counts all self-employed and small businesses conducted solely via Internet, such as TGL itself.

Third, he had also pointed out?actually his source was his client?that although the residents of the coastal regions of the country had seen the most gains in home prices, they are not the most leveraged on their homes. Therefore, in any downturn in the housing sector, they are not going to be unduly burdened by their debt levels. Their debt load is light and, hence, their spending patterns would not be unduly impaired.

Fourth, in an unrelated rese-arch, Goldman Sachs/JB Were provides a detailed cohort analysis of income, wealth and debt levels in Australia, and using that analysis, explains that housing-related debt was assumed the most by those who were at the peak of their earning capacity. Is that the reason why the much-anticipated crash in the housing sector in Australia did not occur? Indeed, I am prepared to wager that an analysis of the other Anglo-Saxon economies?the US and the UK?would throw up similar conclusions.

Fifth, it is entirely possible that any further tightening in the US by the Federal Reserve leads to a significant slowdown in the economy by the second half of 2007. But, will that be short and shallow or severe? Recessions are caused or aggravated by excess optimism on demand. Once demand is curtailed by interest rates or external shocks, businesses find themselves saddled with excess inventory. They cut back on production, lay off workers and further compound the business cycle slowdown. However, supply chain management has meant that most companies carry little or no inventory. At the macro-level, although business inventories have been rising, the total business inventory/sales ratio in the US has fallen from around 1.55 in the early 1990s to around 1.26 now. It does not presage a recession.

Finally, the recent rise in the price of crude oil has as much to do with the worsening environment in West Asia, as it has to do with strong demand and tight supply. Prices of base metals, too, have almost clawed their way back to the levels prevailing before the decline that started in mid-May. Either it reflects renewed speculation or strong global demand or both. Under both scenarios, interest rates would have to rise.

In a nutshell, optimism that the US rate cycle has peaked has stemmed more from clumsy communication by the Federal Reserve rather than from a cogent analysis of the real economy. The latter appears to be in good health and in need of additional interest rate medicine. The Federal funds rate might have to be increased to 6.0%. All this means that the recovery seen in emerging stock markets, such as India?s, is more likely to be ephemeral than eternal.

?The writer is founder-director, Libran Asset Management (Pte) Ltd, based in Singapore. The views are personal