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Global Briefing: World Markets Watch the Fed

Equity markets are down across the board ahead of Tuesday's FOMC meeting.

Fear that higher U.S. inflation will prompt the Federal Reserve to tighten U.S. monetary policy is the key force driving the global capital markets today.

Global interest rates are mostly higher and equity markets universally lower. The dollar is firmer against the yen, but little changed against most European currencies.

Last Friday's April CPI figures helped solidify market expectations for Fed policy.

The consensus now expects the Federal Reserve to announce a bias in favor of tightening to be followed up with a 25-basis-point rate hike, most likely at the Aug. 24


meeting. At one point Friday, the September fed funds futures contract discounted the entire 25-basis-point hike. At the close of the session, the June contract, which gives the cleanest read for Tuesday's meeting, reflected about a 25% chance of a hike. The July contract, which offers greatest insight into expectations for the June 30 meeting, had about half a 25-basis-point hike priced in.

In other words, the collective wisdom of the market put the odds at about 50% that the Fed would raise rates 25 basis points. This is roughly twice the chance that the market perceived as recently as the day before the CPI report. At settlement the price of the September contract reflected an 80% chance of a hike.

There are three important things to note about this analysis.

First, despite the drama after the CPI release, the data strengthened the market's view in the direction it was already leaning. Now it leans with greater confidence. Second, the market does not expect the Fed move to be one of a series of hikes. Just like the Fed took out an insurance policy last year to protect against a credit crunch and an economic downturn, the market now expects the Fed will take an insurance policy against the risk that continued strong growth will lead to price pressures. Third, when it does move, the Fed can credibly say that it is simply ratifying what the market has already done.

Of course the real relationship between the market and Fed policy is more complicated than this would imply, but it would help confirm the second point -- that at this juncture, the tightening would be a one-off move. I continue to believe that the risk is for a hike sooner rather than later (as outlined in this space

May 7). By waiting for most of the summer, as the fed funds future strip implies, Greenspan & Co. risk some of their hard-won credibility and goodwill.

Most major Asian bourses fell more than 2% today.



lost 2.3% as it slid to its lowest level in six weeks. Banks and large-cap equities like


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led the move. Japanese government bonds managed to eke out minor gains. The yield on the 10-year benchmark slipped a single basis point to 1.23%. The Australian equity market fell 2.3%, its biggest single-day decline in half a year. The yield on its 10-year benchmark bond rose 32 basis points to 6.06%. The Hong Kong market dropped 2.4% and the three-month benchmark rate rose 25 basis points to 5.375%. The Korean market tumbled 2.7%, its fifth consecutive losing session. The yield on its three-year benchmark corporate bond rose 44 basis points to 8.52%. An emergency policymaking meeting was called to try to stem the rise in long-term yields.

European markets, which had a chance Friday to react to the developments in the U.S., have generally fared better than Asia, which was closed when the April CPI figures were released.

European bourses are off around 1.4% near the halfway point of their sessions and stabilizing. Companies that particularly interest rate-sensitive, like insurance companies, and those that are particularly dependent on sales in the U.S. appear to be among the hardest hit. Bond yields are little changed after selling off alongside U.S. Treasuries before the weekend. Of note, the yield curves continue to steepen. The difference between the yield on the German two-year and 10-year bond rose to 140 basis points, a 19-month high. In contrast, that same curve in the U.S. stands near 34 basis points.

On the currency front, a number of developments will help shape market psychology going forward, although they probably won't have much impact today.

First, U.S. Treasury Secretary-designate

Lawrence Summers

wasted no time in confirming that he, like his predecessor, believes a strong dollar is in U.S. interests.

Robert Rubin

had appeared to embrace this doctrine as a question of principle from day one in office. For Summers, this reflects a learning process. Shortly after the 1987 equity crisis, for example, he embraced the conventional wisdom: "Since other nations will not forever trade goods and services in return for American paper, the dollar will eventually fall to a point where we can balance our books." Except for a brief moment around the Gulf War, the U.S. has consistently run a current account deficit. In the last four years the dollar has trended in the opposite direction that would have theoretically brought it into balance.

Second, the

Financial Times

today reports that the


says the U.K. Treasury may need to take specific steps to drive sterling lower if it is to join European economic and monetary union at a sustainable level. While the market recognizes the truth in this, as sterling is trading above levels from which it was ejected from the ERM, it is in no hurry to make the adjustment. Sterling's entry into EMU is at the very least still more than two years away. The market does not share the IMF's sense of urgency. What this points to, however, is sterling's vulnerability when the eurozone economies do recover in a serious way.

Third, German Finance Minister Hans Eichel has warned that the much-awaited German tax reform will likely be delayed another year to January 2001. This is a setback for Chancellor Gerhard Schroeder's government, which had promised tax reform as one of the cornerstones of his platform for the "new middle." Although Germany has a top tax rate of 60% on business, the effective tax rate -- the rate that companies actually pay, due to loopholes, subsidies and the like -- is closer to 38.5%, according to a recent study by the Dutch

Finance Ministry

. That said, the effective German corporate tax rate is the highest within the EU.

Marc Chandler is an independent global markets strategist who writes daily for At the time of publication, he held no positions in the currencies or instruments discussed in this column, although holdings can change at any time. While he cannot provide investment advice or recommendations, he invites you to comment on his column at