The behaviour of global bond markets pose an immediate economic threat, writes John Beggs

There is growing optimism that the recovery under way in the major economies will become more sustainable in the months ahead. The evidence of economic recovery is strongest in the US.

Japan has also shown good progress, while the euro area is in the very early stages. Financial markets have responded to this increasingly positive flow of economic news in a number of ways. Equity markets have made steady progress, bond yields have risen and the US dollar has staged a comeback against European currencies. These developments seem destined to continue.

After a difficult second quarter, the general expectation was that we would see a more sustained improvement in the global economy in the second half of 2003. In the event, real gross domestic product (GDP) growth in the US came in at 2.4 per cent on an annualised basis in the second quarter. However, this is likely to be revised up to about 3 per cent when figures are published this Thursday.

It seems, therefore, from these figures and later survey data for July, that the US was off to a flying start in the second half of the year. It is now expected that the US economy could expand at an annualised rate of 3.5-4 per cent over the next two quarters. If this were to occur, it would be the first sustained above-trend back-to-back quarterly expansion in the US since mid-1999.

Of course, any US economic recovery will be greatly assisted by the existing accommodative fiscal and monetary policies. The US Federal Reserve has maintained the official Fed funds rate at 1 per cent and has indicated that the rate will remain unchanged for a considerable period in view of the low inflationary environment.

Tax cuts and larger public spending will also boost the personal sector, at least in the short term. Of more significance on a longer term basis, is the convincing evidence of an improvement in investment spending. This, together with the continuation of healthy productivity growth, should sustain the recovery into 2004.

Moreover, during the next six months, the US economy should feel the benefit of a rebound in inventories. On the downside for the US economy, stronger growth in domestic demand will raise the level of imports, which will act as a drag on overall US economic expansion.

Figures for the euro zone are not so impressive. The area probably suffered a fall in real GDP in the second quarter with the key economies experiencing outright recession in the first six months of the year. There are some indications, however, that the tide is turning. Today's release of the Ifo survey for August in Germany will be an important indicator of progress.

The zone will benefit from the easing in the value of the euro and from a pick-up in US domestic demand. We can not rule out one last cut in official rates by the European Central Bank. However, it seems likely that the euro zone will lag the US in terms of economic recovery over the next 12 months. While the rate of euro-zone economic growth in 2004 should recover to about 1.8 per cent from this year's sluggish 0.6 per cent, it will fall well short of the projected 3.5 per cent expansion for the US.

Developments in the UK are more promising than in continental Europe. The economy continues to suffer from imbalances in terms of the distribution of economic growth. However, the economy is on course to return to trend growth of around 2.5 per cent in 2004.

So it appears that we are at, or close to, the bottom in terms of the official interest rate cycle in the major economies. With little sign of inflation, any increases in official rates in 2004 will be slow to materialise and of relatively modest proportions. Equity markets have responded well to the growing evidence of economic recovery.

The major equity indices have rebounded significantly from their March lows. The major US indices are up more than 25 per cent with the Nasdaq up more than one-third. In Europe, key indices are up by 25-40 per cent.

The capacity of equity markets to maintain this progress will depend on the sustainability of the economic upswing. The prognosis is favourable in several respects but there remain plenty of risks. The recent and prospective behaviour of international bond markets poses an immediate threat. Bond yields have increased dramatically from their lows in June.

If sustained, this could adversely affect housing activity and corporate investment. Ten-year yields are up 1.25 per cent in the US and 0.75 per cent in the euro area over the past two months. This reflects the market's concern that a return to stronger growth will bring a tightening of monetary policy by the world's central banks.

Needless to say, this will happen in time. Official interest rates are at remarkably low levels and will adjust upwards once we have achieved a sustainable rate of economic growth in the major economies. This should, in turn, provide a more solid underpinning for international equity markets even if bond yields, as expected, move somewhat higher over the next year.

John Beggs is chief economist AIB Global Markets