Global Markets

Many indexes ended the month of May and the first of June, if not at all-time highs, then at six-and-a-half year highs. However, the lofty heights were short-lived. While nowhere near the severity of February’s decline, investors reacted to a sudden sell-off in the bond market. Equities sank as investors worried about the possibility of further increases in central bank interest rates as the Reserve Bank of New Zealand stunned investors and increased its key rate to 8 percent while the European Central Bank did the expected and increased its key rate to 4 percent — with a promise of more to come. Although stocks were already down earlier in the week on profit taking, bond yields soared in the U.S. and abroad on Thursday while stocks swooned.

Strong data in the U.S. removed any prospect of a Federal Reserve rate cut while increases are expected in the EMU, UK, Japan and Australia along with Sweden and Switzerland. Although no new damaging inflation data were available, rhetoric from central bank officials suggest that interest rates will be climbing higher. And the bond market appears to be finally accepting the fact that a rate cut is not in the U.S. future, at least in the near term.

On the week, only the South Korean Kospi gained. Although North American stocks regained their poise on Friday, they were unable to recover earlier losses. All others followed here were down.

Global Stock Market Recap

Europe and the UK

The CAC and DAX were down last week, losing ground every day of the week. After four consecutive daily declines, the FTSE managed to break even on Friday and close unchanged on the day. Inflation tremors shook equity investors as the European Central Bank increased its key interest rate to 4 percent and alluded to further increases in the future while the Bank of England left interest rates unchanged at 5.5 percent. Most analysts, however, see further rate increases on the horizon in the UK and other non-EMU countries. All three indexes are now well below their six-and-a-half year highs that were celebrated just in the prior week. Merger and acquisition news continued to demand investor attentions, but interest rate worries trumped that interest. Investors are fearful that higher borrowing costs will slow profit growth.

Bank of England — a pause that refreshes'

As expected, the Bank of England’s Monetary Policy Committee left its key interest rate at 5.5 percent. The Bank had increased rates in May by a quarter of a percentage point to the current level from 5.25 percent. Most analysts believe that the MPC is waiting to see how effective its previous rate increases have been in reducing inflationary pressures before moving again. In its May Inflation Report, the Bank inferred that additional tightening might be necessary to push inflation down closer to its 2 percent target. The housing market finally appears to be cooling in response to higher mortgage rates according to the Halifax, which showed that May housing prices increased at the slowest monthly pace so far this year.

ECB — no surprise

As universally expected, the European Central Bank increased its key interest rate to a six-year high of 4 percent and signaled that another increase is on the horizon to keep economic growth from fueling inflation. It was the eighth increase since late 2005 and the highest level since August 2001. At his post Governing Council meeting, President Jean Claude Trichet said that monetary policy given the current positive economic environment was still on the accommodative side and that acting in a timely manner would ensure price stability in the medium term. The ECB has expressed concern that companies will push prices up given the current period of strong growth. Labor unions have also been using this period to push for wage increases. Analysts interpreted the use of the word ‘accommodative’ to mean that the Council’s tightness bias continues.

Asia/Pacific

Five of the six indexes followed here were down last week. Only the Kospi gained on the holiday shortened week in South Korea. Stocks dropped the most in seven weeks on concerns that rising global interest rates would curb consumer spending and corporate profits. Auto stocks were hit particularly hard. Global equities generally respond negatively to higher interest rates. Other sectors were hard hit as well including mining companies. In Japan, the Nikkei 225 Stock Average dropped after a report today showed April machinery orders rebounded less than expected. On Friday, indexes plunged more than 1 percent in Japan, Australia, South Korea, Singapore, and Hong Kong.

The trigger for the stock decline was laid at the feet of soaring bond yields. The U.S. Treasury 10-year note fell the most in more than three years, pushing yields to 5.13 percent Thursday. Federal Reserve funds rate options show that as of June 6, the odds of an interest-rate increase to 5.50 percent from 5.25 percent are at almost 41 percent. But only a month earlier, the odds were zero.

Stocks in Hong Kong were down three of five days on interest rate concerns in the high flying property market. Because the Hong Kong dollar is pegged to its U.S. counterpart, movements in Hong Kong interest rates track those in the U.S. Higher borrowing costs could dent demand for bank loans to buy property.

In Japan, stocks responded negatively to April machinery orders data — orders were up 2.2 percent, about half the 4.5 percent gain projected by analysts. Foreigners bought more Japanese shares in the week ending June 1 than at any time since January. Foreign buying had steadily accelerated over the previous month to a 19-week high, according to the finance ministry.

Reserve Bank of Australia on hold for now

Australia's central bank kept its benchmark interest rate unchanged at a six-year high of 6.25 percent for the sixth time after three increases last year tempered inflation. Stable borrowing costs could buoy consumer confidence and fuel a housing recovery. The economy grew at the fastest pace in more than three years in the first quarter, which could ignite inflation and prompt an interest-rate increase in early 2008. The Bank has an inflation target range of between 2 and 3 percent. Inflation in the first quarter was 2.4 percent, down from the fourth quarter’s 3.3 percent reading. The Reserve Bank does not issue an explanatory statement when it leaves interest rates unchanged. The economy expanded 1.6 percent in the first quarter and 3.8 percent on the year. That followed quarter-point interest-rate increases in May, August and November last year to the current 6.25 percent.

Canada

Statistics Canada released its labor and merchandise trade data on Friday. Employment increased, although less than consensus forecasts, while unemployment remained at a multi-year low. The trade surplus increased as distortions from an earlier railway strike worked their way through the data and despite the soaring value of the Canadian dollar against its U.S. counterpart. Stocks were depressed in Canada along with most other world markets, but managed to right themselves on Friday on the positive employment and trade data.

According to research by Adam Posen of the Washington-based Peterson Institute for International Economics and by Kenneth Kuttner of Ohio's Oberlin University the foreign exchange market is the most likely to react to the naming of a central bank chief. In a study of 61 announcements in 15 economies over 30 years, the authors concluded that “in general, markets do care who chairs the central bank'” and are typically jolted when the name of a new leader is revealed. Some announcements create expectations of higher interest rates, while others are consistent with expansionary monetary policy. “Overall, the results do suggest that appointments do contain, or at least are thought to contain, new information about future monetary policy,” according to the report. Canada could be the next test after David Dodge’ announced on April 25 that he would retire as governor of its central bank.

Currencies

The dollar was up against the euro as higher bond yields attracted international investors. The dollar was also higher against the British pound sterling and Swiss franc after Treasury yields reached a five-year high and the U.S. merchandise trade deficit narrowed.

The yen and Swiss franc weakened as higher global interest rates made it more profitable to borrow and sell the Japanese and Swiss currencies to purchase higher-yielding assets, a practice known as the carry trade. The currencies extended their declines as U.S. stocks rebounded.

Indicator scoreboard

EMU — April producer price index was up 0.4 percent and 2.4 percent when compared with the same month a year ago. Higher energy and intermediate goods prices spurred the increase. Excluding construction and energy, the PPI was up 0.4 percent on the month and 3.4 percent on the year. Softer German prices were offset by higher prices in France, Spain and Italy.

April retail sales volumes edged up 0.2 percent and 1.6 percent when compared with last year. Sales were up a revised 4.4 percent and 2.2 percent in March. Core sales (excluding food, drink and tobacco) were even softer posting a monthly increase of just 0.1 percent and would have been weaker still but for a sharp recovery in Germany where the pattern of demand continues to be distorted by the effects of January's hike in VAT.

Germany — April manufacturing orders dropped 1.2 percent but were up 7.9 percent when compared with last year. Both domestic and foreign orders were down. Domestic orders were down 1.5 percent but up 7.4 percent on the year. Orders were down for both basic and capital goods while consumer & durable goods gained. Foreign orders were down 0.7 percent and up 8.6 percent on the year. While basic goods orders declined on the month, both capital goods and consumer & durable goods orders were up.

April industrial production sank 2.3 percent and was up 3.7 percent when compared with the same month a year ago. Manufacturing slumped 2.4 percent, intermediate goods declined by 3.6 percent and the consumer goods sector contracted by 1.1 percent. In the consumer sector, durables dropped 4.3 percent while nondurables declined 0.4 percent.

April merchandise trade surplus edged up to €15.8 billion from €15.6 billion. Exports were up 0.9 percent while imports were up 0.8 percent. The annual growth rate of exports climbed back into double digits (13.1 percent) and in large part reflected strong demand from other EU countries. Total imports were up 8.9 percent year-on-year.

France — April merchandise trade deficit widened to €2.8 billion, almost double March’s deficit of €1.5 billion. The deterioration was in large part attributable to a worsening in net trade with the rest of Europe where imports grew 3.5 percent on the month while exports fell 2.4 percent. Within total exports, a modest rise in capital goods was more than offset by a decline in basics and auto-related products.

Italy — First quarter gross domestic product was up 0.3 percent and 2.3 percent when compared with the same quarter a year ago. Consumer spending, which makes up two-thirds of the economy, rose 0.7 percent. In the fourth quarter, the economy grew 1.1 percent, the fastest pace in seven years. Gross fixed investments were up 0.7 percent on the quarter in the first quarter of 2007, compared with 1.7 percent growth in the fourth quarter of 2006. Exports grew just 0.4 percent on the quarter after rising 4.5 percent in the fourth quarter of 2006.

United Kingdom — April industrial output was up 0.3 percent and 0.4 percent when compared with the same month a year ago. With the exception of a warm weather related slide in the electricity, gas and water sector, all of the broader categories posted gains with the erratic mining and quarrying and oil and gas extraction sectors leading the way with a 1 percent gain on the month. Manufacturing output was up 0.3 percent and 1.3 percent on the year on the back of widespread increases among the major sectors. The largest single gain was in transport equipment industries, up 0.9 percent.

Asia/Pacific

Australia — First quarter gross domestic product jumped 1.6 percent and was up 3.8 percent when compared with the same quarter a year ago. This is the fastest pace in more than three years. Growth was driven by consumer spending and business investment as mining companies in the world's largest exporter of iron ore and coal expanded to meet demand. Gross fixed capital formation was up 2 percent on the quarter and 5.8 percent on the year. Final consumption was up 1.3 percent and 4 percent on the year. The GDP chain price index was up 1 percent and 4.3 percent on the year.

May employment increased by 39,400 to 10,453,800. Full-time employment was up 66,800 to 7,530,000 but part-time was down by 27,400 to 2,923,800. The unemployment rate dropped to 4.2 percent from 4.4 percent in April. The number of unemployed declined by 11,800 to 463,000. The participation rate increased by 0.1 percentage point to 65.0 percent.

Americas

Canada — May employment was up by 9,300 jobs. Full time jobs were up 32,700 though part time jobs were down 23,400. Goods-producing sector gained 15,700 jobs but the service sector lost 6,400 jobs. Manufacturing jobs declined 12,300 while forestry, fishing, mining, oil & gas lost 8,300. However construction jobs increased by 21,900 and utilities climbed by 10,400. In services, trade jobs were down 20,300 and health care & social services declined by 11,600. These losses were partially offset by gains in information, culture & recreation, up 16,300, and accommodation & food services, up 15,300. Self employment jobs jumped by 56,000 jobs while private sector employments sank by 58,000. The unemployment rate remained at 6.1 percent for the fourth month, a 33-year low.

April merchandise trade surplus expanded to C$5.76 billion from a revised C$5.1 billion surplus in March. Exports edged down 0.3 percent to C$40.7 billion from a revised C$40.8 billion in March. Imports dropped 2.2 percent to C$34.9 billion, driven by declines in all sectors except energy. While the surplus with the United States edged down to C$8.0 billion, the deficit with the rest of the world narrowed to C$2.3 billion. Exports to countries other than the United States reached C$10.1 billion, a 7.7 percent gain. Imports from those countries remained virtually unchanged at C$12.4 billion. Exports to the United States dropped 2.6 percent to C$30.6 billion, while imports from the U.S. decreased 3.3 percent to C$22.6 billion.

Bottom line

Last week proved to be a turbulent one for bonds and stocks. The realization that the trajectory for interest rates was really higher spooked equity investors who sold stocks because they were fearful of lower profitability. In reality, given recent equity gains, profit taking and a ‘correction’ should have been expected. With North American markets ending the week on an up note, it will be interesting to see if Asia and Europe follow suit on Monday.

Inflation indicators will be released for the U.S., UK and other major countries this week. They will be watched carefully for inflationary trends that could lead to further interest rate increases. The Bank of Japan holds its monthly meeting — no interest rate change is anticipated. Investors will pay close attention to the anecdotal evidence about the U.S. economy contained in the Beige Book.

Looking Ahead: June 11 through June 15, 2007

Anne D Picker is the author of International Economic Indicators and Central Banks.