The butterfly flapping over Latvian real estate

  • 2004-07-15
  • By Zigurds Vaikulis
Ever heard of the so-called "butterfly effect?" According to the theory, a butterfly flapping its wings on one side of the planet can cause a tornado on the other side. Well, the Federal Reserve System has recently started flapping its wings on monetary policy, and the highly globalized world of finance is now on a major tornado alert.

As everyone is aware, the Federal Reserve is no longer just the central bank of the United States, and the dollar is not just an American national currency. Any move made by the Fed immediately affects each and every corner of the world where dollars are in use in the form of credit/deposit or foreign reserve currency. The use of foreign currency, especially the dollar, is more pronounced in emerging markets - and Latvia is no exception.
The core task of every central bank is to attain balanced economic growth while simultaneously maintaining price stability. This means that central banks try to smoothen traditional economic cycles - easing recessions at the bottom of the cycle and dampening inflation on the top. During the last four years the Fed (as well as other central banks) has been using its monetary instruments to jumpstart the economy. Now it's evident that the economies of developed countries have turned the corner, and any further monetary stimuli have become redundant-even undesirable-as they may lead to overheating and excessive inflation. In the U.S.A., the first step toward monetary tightening was made at the end of June when the Fed funds rate was raised 25 basis points to 1.25 percent. This was just the beginning, and the "million dollar question" now is how aggressive the Fed will be in removing its accommodative policy.
In our opinion, not very. The major goal of the Fed right now is to get rid of superfluous protection against deflationary risks; therefore, in the coming months the Fed funds rate will be increased by 50 more basis points, to end the year at 1.75 percent. During 2005 the rate might add another 100 points, reaching 2.75 percent - 3 percent. For interbank dollar rates, that would imply an increase to approximately 3.5 percent - 4 percent.
The recovery processes in the euro zone remains fragile, so talk of euro-rate hikes is nonexistent. But even here the situation has started to change. Despite the European Central Bank positioning itself as an independent institution, it seems that even it can't escape the influence of current changes in the global monetary climate.
It's worth recalling that not too long ago the financial community was actively discussing the necessity to cut euro rates, but in the current tightening environment this idea has been forgotten. Quite possibly the ECB will start weighing the possibility of raising rates in the beginning of 2005. But given the absence of fundamental justification for such a decision, the scale of the rate increase is hard to identify. Considering that euro and dollar rates tend to correlate, it's possible to assume that we'll see interbank euro rates approaching the 3 percent level in about a year. We can even say, with a high degree of certainty, that during the next six months dollar rates will rise above those for the euro-something not seen in the last several years.
What are the implications for global financial markets? First, monetary tightening will negatively affect all debt markets, and this can already be felt now. In the last several months bond prices have dropped sharply. Even though some short-term positive corrections are possible, we doubt that bond portfolios will be able to show delightful returns in the next 12 months. This is especially true for lower quality debt, which is more sensitive to the risks related to interest rates (there is even a theory that relates Fed interest rate cycles to emerging market crises), which is why investors are especially cautious about the clouds surrounding emerging markets.
Furthermore, interest rate tightening usually serves as a cold shower for real estate markets, which have demonstrated a rapid growth not only in Latvia but also in the U.S.A., the U.K. and elsewhere. For Latvia, this is likely to be the most visible consequence of growing dollar rates: We may witness a price correction in many segments of the local real estate market. Like in any other markets, the current price of property reflects investors' expectations of its future price. Decrease in demand may be enough to sharply alter these expectations. So, should you contemplate purchasing, on credit, a little piece of land somewhere in Latgale, don't forget about the butterfly flipping its wings on the other side of the Atlantic.

Zigurds Vaikulis is head of research at Parex Asset Management.

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