Investor/An insiders guide to the market:At this time of year, the attention of investors and investment analysts turns away from 2006 and begins to focus on prospects for the coming year.

Barring a major unforeseen event, the investment script for 2006 has already been written. In general, it has been a very good year for investors, with equity and property markets producing exceptionally strong returns.

A key element in any assessment of investment prospects for 2007 is interest rate trends. During 2006, movements in interest rates evolved broadly in line with market expectations. As expected, the Federal Reserve called a halt to its long phase of quarter-point interest rate rises and entered a new phase of holding rates steady.

In Europe, the European Central Bank (ECB) continued with its policy of gradual and incremental increases in its interest rate. In the Far East, the Japanese central bank, in a well-signalled move, called an end to its long period of zero interest rates by announcing an increase in rates to 0.25 per cent. The only surprise during the year came from the Bank of England, which unexpectedly raised UK base rates. Subsequent information regarding the strength of the British housing market and the resilience of the consumer has shown that the bank's move was justified.

In contrast to this time last year, there are sharp differences of opinion regarding 2007 interest rate trends. In the US, the majority view is that the next move by the Fed will be a cut in interest rates, with some commentators expecting a move as early as the first quarter.

The recession in the US housing market and the risk of a hard economic landing in 2007 are reasons put forward in support of this view. However, November data regarding US labour market conditions indicated that the labour market is in very good shape. The November report showed that 132,000 new jobs were created in that month. Furthermore, there was an upward net revision of 42,000 jobs for the previous two months, which means that the average monthly gain over the past six months was 150,000 jobs.

It is estimated that 130,000 jobs need to be created each month to prevent unemployment from rising. This data is consistent with the soft landing scenario and supports the view that the Fed will be very slow to cut shot-term interest rates. Investor's view continues to be that US short-term interest rates will hold at current levels well into 2007.

In Europe, there has been unanimity regarding policy action from the ECB up to and including the last rise, which took European interest rates to 3.5 per cent. Sharp differences of opinion have emerged regarding the next move. Some observers take the view that the ECB will pause at 3.5 per cent, given the strength of the euro and the risks posed by the potential for a hard landing in the US.

Investor's view is that the ECB will continue to raise rates during the first half of 2007 and will probably only pause at 4 per cent. A key reason for taking this view is evidence that the improvements seen in the German economy over the past two years are structural rather than merely cyclical.

As the single biggest euro-zone economy, accounting for 30 per cent of output, German economic performance has a large influence of euro-zone economic policy. If the German economy had been stronger in recent years, there is little doubt but that European interest rates would not have fallen to as low as 2 per cent.

From the start of 2001 to early 2005, the German economy grew by a cumulative 1.2 per cent. In the subsequent 1½ years, the economy accelerated to growth of 3.6 per cent. During this period, Germany has clawed back much of the competitiveness that it lost during the 1990s.

Corporations have restructured and labour cost growth has been kept to a minimum. According to the International Monetary Fund, Germany's real exchange rate, based on unit labour costs, depreciated by 4 per cent between 2000 and the third quarter of 2006.

This compares with an appreciation in the French real exchange rate of 3 per cent over the same period and a 33 per cent appreciation in Italy.

Private consumption has been slow to recover in Germany and some economists are concerned that the planned 3 per cent hike in the VAT rate could seriously dampen demand.

However, this increase was announced so far in advance that it has probably been fully factored into consumer behaviour already.

Even if it does lead to a transitory fall in consumption, the structural improvements in the German economy should be sufficient to result in another good economic performance in 2007. Continued strength in Germany points towards further ECB rate rises in the first half of 2007.

Investor says . . .The continued strength of the German economy points towards further interest rate rises in the first half of 2007