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Larry Wee: On the home front, Prime Minister Lee Hsien Loong revealed early last month that Singapore registered GDP growth of more than 10 per cent in Q1 2006. Since then, the official growth forecast range for 2006 has been raised to 5-7 per cent, from 4-6 per cent before.

When you juxtapose this strong growth picture and high oil/commodity prices against the Monetary Authority of Singapore's (MAS) decision not to tighten its monetary stance at its semi-annual review last month, would it be fair to conclude that local interest rates have further room to rise?

David Carbon: The thing to remember is that Singapore's monetary policy is conducted via its currency, and local interest rates are largely, though not entirely, left to float in the breeze of market forces and sentiment.

What this means then is that interest rates are more likely to fall than to rise going forward. The logic is straightforward: Asia is seeing a lot of capital inflow and governments, including Singapore's, have intervened to cap currency appreciation. This puts more liquidity into the system than would otherwise have been the case and rates are under downward pressure.

In Singapore, three-month interbank rates have been steady at 3.35-3.45 per cent for the past five months even though the Fed hiked 75 basis points (bp), and G3 rates, on average, have risen by 50 bp.

Perhaps the real question you're asking is whether the MAS will change its mind and tighten policy later in the year. There's nothing to prevent them from doing this. If they sense that growth and/or inflation is stronger than what was expected back in April, they'll move before (the next policy review in) October. They're practical, like most central bankers. And frankly, it wouldn't be a big surprise if that were to occur.

Selena Ling: In fact, local consumer price inflation appears to be relatively contained, rising 1.3 per cent year-on-year for the January to April 2006 period. It is based on the expectations of growth momentum moderating in the second half of 2006, and still contained inflationary pressures, that MAS kept its monetary policy bias unchanged in April for a 'gradual and modest appreciation' of the S$NEER policy band. (S$NEER stands for the nominal effective exchange rate of the S$, a trade-weighted value of the local currency monitored and tweaked by the MAS.)

Moreover, downside risks to the sanguine economic outlook still persist. These include market concerns that the US Federal Reserve may overshoot in tightening interest rates and contribute to a US growth slowdown. In addition, the risk of a bird flu pandemic in Asia, with the possibility of human-to-human transmission, cannot be ruled out.

And, given the strength of the Singapore dollar to date (it has appreciated more than 4 per cent against the US dollar since early 2006), the domestic liquidity conditions should be sufficient to accommodate Singapore interbank rates (Sibor) from rising much further. In fact, the overnight rate has dipped below the 3 per cent threshold level since May 17, and Sibor rates have stabilised somewhat in the past month.

Nizam Idris: The Sibor and the overnight money rates here have risen to above the levels seen in 2000, even though the US Fed rates have stayed below those seen at the peak seen in 2000. This means the Sibor-Libor differential is already very tight at 170 bp relative to historical averages and the 425 bp seen in 2000, when the MAS was on a more aggressive tightening bias.

Liquidity is still flush and I do not see very strong reasons to believe the Sibor-Libor differentials will fall significantly for now. Differentials below 100 bp like those seen between 2002 and 2004 are rare and were caused more by the historical low in US rates during the period. We will not get back to those sorts of differentials for a while.

Jimmy Koh: It might appear that the MAS' perception of the inflationary trajectory is slightly different from that of the market, as indicated in its recent policy statement that 'wage growth should be well-contained, and sustained growth in productivity should keep unit labour costs subdued'.

Nonetheless, given Singapore's small and open economy, we maintain that if domestic price pressure does build up, and assuming economic growth momentum continues, the MAS will tweak the Sing's value as a counter-cyclical policy instead of raising the local cost of funds.

As for interest rate direction, the main determining factors are: (1) global cost of funds, in particular US interest rates; and (2) domestic credit demand. On the former, consensus is that the US interest rates should peak fairly soon, at most by another 25 bp to 5.25 per cent at the June 29 FOMC meeting.

On the latter, despite the improving domestic outlook, Singapore's loans-to-deposits ratio has dipped to a historical low of 78.9 per cent in March. Thus, we are unlikely to see a significant rise in local interest rates for the rest of this year.

Larry: Where do you expect the benchmark three-month Sibor and 10-year government bond yield - both quite close to 3.5 per cent currently - to peak in 2006? And why?

David: We think that the three-month Sibor is likely to stay flat at 3.45-3.5 per cent for the rest of the year. That's based on the belief that the Fed stays put at 5 per cent. If you put the Fed at 5.25 per cent, we would probably see Sibor at 3.6 per cent, no more.

Selena: Given rising US interest rate concerns, profit-taking in the emerging and commodity markets have recently cast a shadow over Asian markets. For Sing interest rates, the announcement of the introduction of the Singapore dollar Standing Facility from June 1 and proposed enhancements to the liquidity risk supervision framework (to include an expanded range of eligible liquid assets) - coupled with risk reduction plays across Asia - have contributed to the overnight rate easing below 3 per cent more recently.

The one to 12-month Sibor rates also appear to have stabilised, with the three-month Sibor hugging the 3.4375 to 3.45 per cent range in recent weeks, even if strong economic fundamentals point to a steeper yield curve going forward. Our forecast is for the benchmark three-month Sibor to peak at 3.55 per cent in the third quarter of 2006, before easing to around 3.3 per cent towards year-end and into the first quarter of 2007. We see the 10-year government bond yield rising to 3.8 to 4 per cent by year-end. Nizam: They should probably peak at just below 4 per cent.

Jimmy: Our call is that the three-month Sibor will end the year at 3.5 per cent, and then possibly inch higher to 3.6 per cent by end-2007. Of course, this is contingent on no major hiccups in the global arena.

At the far end of the Sing yield curve, given the lack of domestic interest rate policy, yields will be very much dictated by its US equivalent. As the US yield curve is likely to remain flat, our call is that the Singapore government securities (SGS) 10-year yields will be capped at 3.8 to 4 per cent for the rest of this year.

However, recent proposals by the MAS (if/when implemented) to expand the range of assets which qualify as eligible liquid assets could have some long-term impact on SGS yields. Besides cash and the SGS, MAS proposes that investment grade Singapore dollar denominated debt securities issued by supranationals, statutory boards, banks and corporates will also qualify as eligible liquid assets. This may reduce the long-term demand for SGS, and lift yields across the SGS curve.

Larry: From another perspective, what's the scope for a steeper Singapore dollar yield curve by the end of this year?

David: We expect some steepening in the yield curve, but not a lot. Strong growth and higher inflation is likely to pressure the back-end, and take 10-year yields up towards 3.75-3.85 per cent.

Selena: Given the strong economic fundamentals of the Singapore economy in 2006, the domestic yield curve should logically steepen. The two- versus 10-year government bond yield spread is currently about 60 bp, off the low of 35 bp seen at the end of March, but should steepen to around 90 to 100 basis points by year-end. As a historical comparison, it was trading at an average of 157 basis points over the last five years.

MAS has scheduled re-openings of the five-year government bond on June 1, the seven-year government bond on July 3, and the 15-year government bond on Sept 1. The usual size for re-opening of the government bonds range between $1 and $1.5 billion. This impending new supply may also add to the upside pressure on longer-dated yields and thus instigate a curve steepening bias - especially if accompanied by a rising rate environment elsewhere.

Nizam: By the end of the year, the curve may not show significant changes. The market would still be looking at the global economy and Fed rate trends. The former may stabilise while the latter may show early signs of a new Fed easing cycle emerging by the end of this year. Any steepening should therefore be modest.

Jimmy: Fairly unlikely, unless global inflationary pressures build up, resulting in a steeper US yield curve. Also to be considered are Asian central banks' purchases of US Treasuries, and the fact that the Sing will continue to be sought as proxy for a stronger Chinese yuan. Both factors should keep the local yield curve relatively flat.

Larry: On the external front, meanwhile, there's still some possibility of at least a pause in the US rate hike cycle since 2004, after a 16th quarter-point hike to 5 per cent earlier this month. On the other hand, this has to be balanced against the likelihood of further hikes in the Eurozone and Japan over the course of this year. Is this mixed external picture likely to affect the trajectory of Sing interest rates in 2006?

David: You've hit the nail on the head. Singapore runs a 'basket peg' currency policy (of mainly dollars, euro and yen) so interest rates will be 'pegged' to that basket interest rate, at least in the medium term. At DBS, we call this basket interest rate the TWibor, which we think is still headed up for the rest of the year. Even though we reckon the US Fed is done, Europe and Japan still have some catching up to do.

However, we also believe that with appreciation of the S$NEER - the trade-weighted valued of the Singapore dollar adopted by the MAS as its main monetary policy tool - Sibor typically runs below TWibor. That's because currency gains compensate for the lower carry that would otherwise lead to capital outflows. And so the bottom line is that Sibor runs flat for the rest of the year.

Selena: Although the interest rate environment in the Eurozone and Japan appears to be on the uptrend, what is probably more critical is that the growth environment for both will be demand-led and robust, if not accelerating, in the second half of 2006.

The International Monetary Fund (IMF) forecasts that GDP growth in the Eurozone and Japan would accelerate from 1.3 and 2.7 per cent respectively in 2005 to 2 and 2.8 per cent this year, before slowing to 1.9 and 2 per cent in 2007.

Given the important economic and trade linkages with these key trading partners, the latter should be a net positive for the Singapore economy. The Eurozone and Japan accounted for 18.8 and 6.7 per cent of Singapore's total non-oil domestic exports in 2005, compared to the United States' 14.4 per cent share.

Jimmy: Our view is that the global environment has become a lot more stable over the last few years, and that has permitted the Eurozone and Japan to catch up with the on-going Fed monetary tightening campaign. Indeed, market participants have now fully priced in short-term interest rates of 5.25 per cent for the Fed, 3.25 per cent for the European Central Bank and 0.75 per cent for the Bank of Japan this year.

Thus, further upside lift in the near-term for Singapore dollar interest rates from this particular external consideration are only possible if the Fed stretches beyond 5.25 per cent over the coming two months.

Larry: How important would be the influence of higher interest rates in Malaysia and China - another two very important trading partners for Singapore? Are they likely to raise their own rates much further this year?

David: For now, Malaysian and Chinese rates are minor influences on Singapore. Not only are capital flows for the two restricted, but the influence on Singapore rates would come via the exchange rate anyway. We expect another hike or two in Malaysia, and further tightening in China too.

We think another 50 bp in hikes is coming in China this year, on top of a resumption of a 4 per cent appreciation path for the yuan against the dollar - plus some tightening measures on the administrative side to boot. This sounds like a lot but it's really pretty modest tightening, and it should help sustain the growth drive there. It's good for China and for the rest of Asia.

Selena: Their interest rate policy decisions would clearly play an important role in influencing the credit, consumer spending and GDP growth environment in Asia, given the strong trade linkages within the region, especially with China.

For instance, China and Malaysia accounted for 9.7 and 8.7 per cent of Singapore's total non-oil domestic exports in 2005. Bank Negara Malaysia chose to keep its Overnight Policy Rate (OPR) unchanged at 3.5 per cent at its recent monetary policy meeting in May, after three hikes since November 2006 to contain inflation, but have indicated that policymakers are 'vigilant' to inflation risks.

Given that Tenaga Nasional, the country's biggest power producer, has received approval to raise electricity tariffs by an average of 12 per cent for the first time since May 1997 as rising fuel prices cut operating margins, there are upside risks to inflation - although those with average monthly usage of 200 kilowatts-hours or less will not be charged more.

The electricity tariff hike is likely to exacerbate energy-driven inflationary pressure since the Malaysian government had also increased retail fuel prices five times since May 2004. The consumer price inflation (CPI), which hit 4.8 per cent year-on-year in March 2006 before easing slightly to 4.6 in April, may continue to exceed the official 2006 CPI forecast of 3.5-4 per cent in the next couple of months.

For China, we foresee that the People's Bank of China (PBOC) is likely to hike at least one more time to bring its benchmark one-year lending rate from the current 5.85 per cent to around 6 per cent by year-end.

This is aimed at cooling the credit-fuelled investment boom as the Chinese economy expanded by 10.3 per cent in the first quarter, rather than combating inflation which remains relatively well-contained below 2 per cent. This comes on the back of a 27 basis point hike on April 28, which marked the first increase in 19 months.

Nizam: Both can be expected to raise rates further - Malaysia perhaps to 4 to 4.25 per cent, China to 6 per cent - but these are not likely to influence Singapore's domestic rates too significantly.

Jimmy: Although the cost of funds in Malaysia and China are heading higher, the increases are driven by different factors compared to Singapore. In Malaysia, interest rates are merely catching up with on-going global rate hikes, as Malaysia is now more willing to allow the effect of fuel prices to work through the system through gradual unwinding of fuel subsidies.

Also, given the higher inflation trajectory, Malaysia's real interest rates are actually comparatively lower than Singapore's. China, meanwhile, has surprised financial markets by hiking its benchmark one-year lending rate by 27 bp to 5.85 per cent. Their purpose was to head off over-investment in the country, which could be economically destabilising in the longer-term.

Nonetheless, we see rates in the regional economies peaking soon unless evidence of second-round effects from higher commodity prices become more apparent.

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