Investor: As expected, the Federal Reserve last week continued to implement its policy of gradually increasing short-term interest rates. Any negative impact on the economy from Hurricane Katrina was deemed to be transitory, as the coming rebuilding effort adds to growth in 2006.

The Fed funds' rate now stands at 3.75 per cent and further rises in quarter-point instalments are a racing certainty in coming months.

In the money market, one-year dollar interest rates are quoted at 4.3 per cent, which indicates that the markets expect US short-term interest rates to rise by between half and one percentage point before they peak.

Even though one-year money in the US is now trading at just over 4 per cent, the yield on longer dated bonds has barely budged. The yield on the 10-year bond is currently 4.25 per cent, which is just 0.05 per cent higher than last month, and only 0.22 per cent higher than a year ago.

In fact, for the longest dated bond, which matures in 2031, the yield has actually fallen over the past year to its current level of 4.5 per cent.

In financial market jargon, the yield curve has flattened over the past year, ie the gap between short-term interest rates and long-term bond yields has narrowed. The magnitude of this contraction in yield spreads has been very large. This time last year, the Fed funds' rate was just 1.5 per cent, compared with 4.75 per cent on long-dated bonds. This gap of 3.25 per cent has now narrowed to just 0.75 per cent and could be eliminated by early next year.

There is an intense debate in the financial markets as to why the yield curve has flattened in this way. On the basis of historical evidence, most investment analysts anticipated some increase in US long-term yields during this phase of rising short-term interest rates. Even Fed chairman Alan Greenspan has expressed puzzlement at the persistence of very low yields on long-term bonds.

One consequence of this yield curve flattening is that any negative impact on economic activity caused by higher interest rates will be dampened by the stimulatory impact of low long-term yields. It is therefore not surprising to find that the US economy has continued to grow healthily over the past year.

In contrast, the equity market has struggled, as evidenced by the performance of the S&P 500 index, which has barely budged so far this year. Overseas investors in the US market have, however, had the consolation of a recovering dollar so that the euro-based investor has enjoyed returns of approximately 12 per cent in 2005.

This is still not as good as the year-to-date returns in Europe, where the FTSE E300 index has gained 16 per cent so far in 2005.

However, we have to look to the Far East to find the best performing major stock market this year. After many years in the doldrums, the Japanese market has performed strongly in 2005. In local currency terms, the year-to-date return from the Nikkei index is almost 17 per cent and, due to a resilient yen, the return is 20 per cent when expressed in euro.

Over the past ten years, there have been several false dawns in Japan, when investors thought that the long bear market had finished, only to be subsequently sorely disappointed. The depth and severity of the Japanese stock market's malaise can be gauged by the fact that the Nikkei index is still trading two-thirds below its all-time peak, reached as far back as in 1989.

Deflation and close to zero interest rates have dogged the Japanese economy for over a decade. However, over the past year the economy has improved and there are high hopes that the long period of deflation may finally be coming to an end.

In contrast to the outcome of the recent German election, the Japanese electorate recently installed a pro-reform government that has triggered substantial investment in Japan by international funds.

Because of differences in accounting conventions, it has always been difficult to compare the valuation of Japanese equities with their Western counterparts. The price-earnings ratio (PER) of the overall market is low compared with its own historical average, but is still much higher than the average PERs in western markets.

In Investor's view, the decision to invest in Japan needs to be based on a subjective view of likely long-term trends, rather than an analysis of the somewhat flawed valuation yardsticks as they apply in Japan.