US rate alert rattles financial markets

Financial markets around the world this week are facing one important question - by how much will American interest rates be raised?

The issue is no longer if the Federal Reserve board will act to raise the cost of borrowing but when, and to what extent.

When is widely believed to be Wednesday, after a two-day meeting of the board's open markets committee - with the betting on a quarter-percentage point rise to 5 per cent, with more increases to come.

The bond and equity markets have already factored in an increase in rates after several recent comments from Alan Greenspan, the Federal Reserve chairman, indicating an upward move - "a modest pre-emptive" - was inevitable.

The chances of an increase were also given momentum by the Federal Reserve's last meeting in May, which resulted for the first time in a public statement about the intention to lift rates.

By how much the board will lift rates is the focus of debate among economic pundits and Wall Street observers. Rising US treasury bond yields and falling equity prices over the past few weeks suggest the increase to 5 per cent, but some analysts have said that such an increase would be a "non-event".

Rate rise expectations have already pushed the yield on 30-year government bonds to near 19-month highs, at more than 6 per cent. This yield is unlikely to be sustained if a 25 basis point rise is not announced. Some even expect it to fall unless the Federal Reserve suggests further rises are imminent.

Last week's equity markets also responded to the impending threat of a rate rise. The Dow Jones Industrial Average fell 2.4 per cent, the S&P 500 dropped 1.4 per cent and the technology-driven Nasdaq Composite Index rose almost 1 per cent after some heavy selling.

Internet stocks, which have fallen sharply from record highs in April, may even benefit from a rate rise.

Perversely, shares in these companies, which are typically sensitive to rate increases because of heavy borrowing and also the biggest gainers from the booming US economy of recent years, could gain if the Fed does raise rates as the latest round of certain uncertainty is ended.

Such rationale was underlined by Abby Joseph Cohen -the chief equity strategist at Goldman Sachs, the US investment bank - who issued a bullish note on the market during last week.

Ms Cohen, who has become one of Wall Street's most respected pundits for her continued faith in the bull market, believes that action from the Federal Reserve will not harm the stock market. It could help, she argues, as it would show that it is taking signs of rising inflation seriously and making sure that the "Goldilocks" economic cycle remains neither too hot nor too cold.

There is also a Panglossian view that even a 50 basis-point increase will be beneficial to markets as it removes any uncertainty about the Federal Reserve's future actions. This view suggests that markets will not be satisfied until the 75 basis points cut last autumn during the global market turmoil are recovered.

Rising rates will further strengthen the dollar and increase pressure on currencies such as the euro, and sterling is expected to suffer following recent UK rate cuts.