Higher rates needn't scare investors

This will be the year of rising interest rates. Short-term rates will rise swiftly in the UK, more slowly in the US and - by the end of 1997 - also begin to rise across continental Europe. The key test for financial markets will be to see how confidently investors can look beyond this cyclical rise and discern the longer-term downward trend. If they are frightened by the rise then it will be a bumpy year for both bonds and currencies; if they can take the long view then the sunlit uplands still beckon.

It will be interesting to view the year from Britain. That is not because what happens to UK domestic markets has much influence on the rest of the world. It doesn't. The tail does not wag the dog. Rather it is because the upturn in interest rates will happen here first. It will happen because the new government, whoever is running it, will have to lean against strong economic growth as one-off boosts (from things like the building society conversions to plc status) add to strong underlying demand.

The result will be strong pressure on the Chancellor, whoever he may be, to get interest rates up fast. The quicker he responds, the less damage there will be to long-term interest rates, but a sharp rise in short rates will inevitably make sterling more attractive. So sterling should remain strong too.

How high will short-term rates go and how much effect will this have on the pound? UK base rates will probably end the year at or close to 7 per cent. Anyone who tries to call the exact timing of the rises will be wrong, but a plausible profile will be one more quarter point rise before the election and then another three through the summer and autumn. The peak in the interest rate cycle? Probably not till well into 1998.

Impact on gilts? The key here will be the attitude of the next Chancellor. If Labour does get in, the first Budget of the new government will be scrutinised for any use of mirrors to make the figures look better. My guess is that come what may, gilts will have a difficult year, but if there is the prospect of tighter fiscal policy under Labour than under the Tories, then come 1998 the prospects will look much brighter.

The impact on the pound? Well, the problem here is that a lot of that impact is already in the market: sterling shot up in the final quarter of last year and from being clearly undervalued is now close to its underlying purchasing power parity. Of course currencies can, and do, overshoot. It is perfectly possible that sterling will become too strong during the course of this year. In any case there are two sides to the currency equation and whatever happens to the pound will be determined by what happens to the dollar and/or the German mark. A rational expectation would be for sterling to continue to strengthen through the early part of this year but for that rise to peak by mid-year. But the forex markets are not noted for their reason, and in any case, with the preparations for EMU they will have bigger fish to fry.

In the US, still the dominant market for the world, there will also be a rise in interest rates. The Federal Reserve has its next policy meeting in early February by which stage it will be clear how sustained the present acceleration is growth is likely to be. The bigger question will be later in the year: will the long expansion in the US come to an end of its own accord or will there have to be several rises in rates to choke it off. Mainstream expectation: a couple of further rises in US rates during the course of this year, but no savage tightening. Providing the Fed does act in February there need be no fall-out in the bond market, but at best bond yields will move sideways.

But that does not mean that the 15 year long-term downward trend of bond yields, in the US as well as in continental Europe, is ended. As the graph shows this is a solid long-term trend. Now at some stage that will end once it becomes clear that the downward trend in inflation cannot proceed any further. But this year I think we just see a pause on that downward path.

The dollar? Probably some more strength, as the gradual, patchy recovery continues. But the main influence on the dollar will be what happens to the European currencies. If the euro is going to be a weak currency, as now seems more and more likely, then the dollar's safe haven status will be enhanced. If plans for the EMU fall to bits - maybe not likely but certainly possible - then expect the mark to resume its status as the world's "best" currency.

And so to continental markets. Here the rise in interest rates will not happen until well into the autumn, maybe not till 1998.

Bond markets will take courage from this, but currencies will struggle.

The single biggest question for bonds and currencies is whether the long-term downward trend of inflation really solid? I think it is. If so, expect a stormy year but with calm water beyond.