Rates back to fixate investors

Financial markets have swung back into a new but familiar phase — worrying about interest rates — and, not coincidently, the euro zone debt crisis is also bubbling after a brief hiatus.

It all points to a couple of weeks ahead that are likely to be volatile — risk-on, risk-off — with a particular focus on the U.S. Federal Reserve’s meeting on April 26.

The interest rate issue is at its most obvious on the foreign exchange market, where carry trading has returned. Investors are borrowing in low-yielding currencies to invest in higher-yielding ones.

The euro, for example, is at its highest in 15 months against the dollar.

This is being driven by yield differentials now available after the European Central Bank raised interest rates (with more likely to come) while Japan keeps monetary conditions ultra-loose following its devastating earthquake and tsunami.

A sort of middle ground is being held by the Fed, which is not likely to raise rates until next year, but which has to decide on the future of its asset-buying quantative easing (QE) programme, due to end in June.

It is at this point that equity investors come into the picture. QE has produced a flood of liquidity into markets that has essentially driven investors into stocks, in part because it has made a lot of fixed income unattractive.

Equity markets have been remarkably resilient, shrugging off just about everything that is being thrown at them, from rocketing oil prices, wobbly euro zone debt, a big blow to Japan’s economy, and a revolt in the Arab world.

Gary Baker, head of European equity strategy for Bank of America-Merrill Lynch, says equity investors are actually “reluctant bulls” who can’t fight Fed-driven liquidity.

“They see very little alternative to equities,” he said.

It all makes markets highly vulnerable to sudden, surprising change. So any comments from the various factions in the U.S. central bank hierarchy over the next few weeks may be even more market-moving than usual.

Flash PMIs from across the euro zone may also be signposts to the ECB’s next move.

SPILLOVER