Despite recent sabre rattling from the ECB, many economists are convincedthat euro zone interest rates will not move higher until well into the third or fourth quarter of next year, writes Gretchen Friemann.

Property investors hoping for an upturn in the stunted office and industrial sectors were dealt another blow last week after the outbreak of internecine warfare within the EU signalled an earlier than expected interest rate hike.

The breach of imposed spending limits in the stability and growth pact by EU heavyweights, France and Germany, barely provoked a reaction from the financial markets but the European Central Bank warned that the collapse of fiscal discipline carried "serious dangers".

The message was clear. Higher government debt burdens necessitate a rise in short-term interest rates, an unpalatable prospect for the two main economies teetering on the brink of recession.

But it's also an unpleasant reality check for bargain hunters on the look out for competitive borrowing rates.

Although commercial property mortgages track swap rates, a spike in government lending rates usually drives bond prices down as debt investors seek out higher yields. And that in turn leads to higher fixed rate borrowing costs; bad news for the property sector which has weathered a flight of investor cash into the UK and Europe this year following the 3 per cent jump in stamp duty in the last budget.

Retail investors will also be concerned at the threat of a short-term interest rate hike. Apart from the higher borrowing expenses, anything that threatens consumer spending is likely to depress capital values, which have hit record highs this year on the back of a credit boom fuelled by historically low lending rates.

However, for all the sabre rattling from the ECB, many economists remain convinced that interest rates will not move higher in the euro zone until well into the third or fourth quarter.

There are a number of reasons for this but one crucial factor is the parlous state of the two largest economies, France and Germany, and the threat higher interest rates would pose to their tentative recovery.

But before property investors take a collected sigh of relief, it's worth remembering that interest rates rises are not necessarily a negative for the market. Indeed a move upwards usually heralds a return of confidence within the business community and drives up rental values within the office sector.

What is not clear is how the market will react to an interest rate rise designed to counteract soaring government debt.

According to Mr Niall Dunne, chief economist with Ulster Bank, such a scenario is unlikely to develop.

He believes the threatening language emanating from the ECB is aimed at discouraging further breaches and ensuring that the smaller countries continue to toe the fiscal line.

He said: "In the context of the huge deficits carried by the US and Japan, the breach of the 3 per cent borrowing limit by France and Germany is not particularly serious. What no doubt concerns the EU and what would substantially worry the markets, is if that borrowing rate crept up to over 5 per cent by 2005."

If that was to happen, government bonds in both those countries would suffer a price collapse, a prospect neither government wants to risk, Mr Dunne argues.

"French and German government bonds have performed well lately and are viewed as very attractive by the market. I don't think either country would risk a price collapse by engaging in unfettered borrowing."

According to Mr Dunne, a far more important factor in the interest rate story next year is the dollar/euro relationship.

The single currency has enjoyed an extraordinary run of growth lately, hitting 1.25 against the dollar at the time of writing. If the euro was to spike dramatically against the US currency, then Mr Dunne believes the ECB will be forced to either keep rates on hold or cut, depending on the scale and speed of the appreciation.

He claims the threat of a bloody trade war between the US and its main trading partners, Japan, China and the EU, as well as the Bush administration's spiraling deficit, are likely contributors to a currency surge against the greenback.

However, Mr Eoin Fahy, chief economist with KBC asset management, which handles a substantial property portfolio, plays down any talk of interest rate cuts. He claims the interest rate cycle has "drifted upwards" on the back of strong growth in the US and Japan.

He said: "These accelerating rates of growth will drag Europe up next year and we'd be expecting a quarter or half percent rise in the second half of 2004."

Given the improved global economic climate, Mr Fahy is also forecasting equities to outperform property, pointing out that "higher interest rates will make commercial property less advantageous".

Mr Noel Collins, a senior investment consultant with Mercer, agrees that this is the time to begin diversifying Irish property portfolios with overseas acquisitions as the days of "double digit returns here are no longer sustainable."

He said Mercer is forecasting the usual breakdown in asset performance, with equities achieving the highest returns, followed by property and then fixed rate assets.

Mercer expects property yields in 2004 to reach 6 or 7 per cent.

The dampening enthusiasm for Irish commercial property is particularly evident in the attitude of institutional investors, most of whom, like Mr Hugh Linehan, fund manager with Hibernian Investments, believe there is little value left in the market.

He said: "We are certainly not looking at disposing any of our property assets at this stage but neither are we particularly interested in buying."

He claims Hibernian is not significantly altering its asset allocation in 2004 with a typical managed pension fund investing 73 per cent in equities, 19 per cent in bonds and 6 per cent in property with the remainder in cash.

However, Mr Adrian Trueick, director of investments with Sherry Fitzgerald's commercial arm DTZ Ireland, claims the apathy of institutional investors towards property is not a significant factor.

He said: "Institutional investors account for so little activity in the commercial property sector these days as to be almost irrelevant. It's the highly geared private investors who are determining values."

Asked if he was concerned that they too could abandon the market, he replied: "There is such a huge demand for property from investors that it can't be satisfied by one market, particularly not in Ireland, given its relatively small size."