Financial forecast.

• Author: Boquist, John A.
• Position: The Big Picture - Economic indicators

As usual, the condition of U.S. financial markets is bipolar. The optimistic side is that the financial markets have been able to absorb tremendous shocks during the past three years: the trauma of 9/11; declining stock market returns from the incredible highs of 2000; the bankruptcies of Enron, Worldcom, United Airlines, and others; sweeping legislation to reform corporate governance practices at companies; and unrelenting global competition. The depressed side is that many new challenges now face the markets: the war in Iraq, massive budget and trade deficits, and record high oil prices. Given these new challenges it is easy to see why financial markets are on edge with investors wondering which direction the markets will go. Fortunately, there are some notable bright spots:

* Housing demand remains strong and families who own their own homes have seen rapid increases in value in many markets.

* Relatively low interest rates have helped sustain the markets, particularly real estate.

The question on everyone's mind is what does the future hold?

Interest Rates

Interest rates have generally fallen for the past twenty years, due in large part to wringing inflation out of the economy. In addition, foreign governments have been buying Treasury securities to shore up their currencies, and domestic investors have been improving the quality of their portfolios in the face of erratic stock market returns. Since short-term rates have fallen much more than the long-term rates, the yield curve continues to be very steep. Historically, the spread between short- and long-term rates is a precursor to economic activity and the currently observed high spread is generally followed by an expansion and rising interest rates. Also, the Federal Reserve has been increasing interest rates in small steps to combat inflationary pressures in the economy. We expect this policy to continue and, as a result, we expect the short-term Fed Funds rate will rise to 2.75 percent by the end of 2005 (see Figure 1). Since we forecast inflation to be 3 percent in the upcoming year, the implication is that short-term real rates of interest will be negative or close to zero, which reduces the effective cost of the use of debt to the borrower. The anticipated inflation will carry long-term Treasury yields up from the current 5 percent level to the 5.5 percent range by the end of 2005. Corporate interest rates will exhibit similar increases next year. Mortgage interest rates...