Three months ago, economists were wringing their hands over the jobless U.S. recovery and predicting that the Fed would not raise interest rates until late 2004, or early 2005.
Now, financial markets are convinced that the Fed will begin raising interest rates later this month.
The difference? A surge in U.S. employment. More than a million jobs have been created – or, perhaps more accurately, discovered by the statisticians – so far in 2004. The labour market has begun to catch up to the rest of the U.S. economy, and the growth trend looks set to continue.
Bond markets, previously frozen in the deflationary headlights, have responded with alacrity. During the summer of 2003, when fears of deflation suddenly evaporated, U.S. 10-year yields rose from 3.1 per cent to 4.6 per cent. Concerns about the jobless recovery caused yields to retreat to around 3.7 per cent during the winter, but now yields have moved even higher, to around 4.8 per cent.
Other bond yields have followed the same two-step pattern, but to varying degrees. Eurobond yields have risen by only about 90 basis points in total, to 4.4 per cent, because the economy, while clearly gathering momentum, remains in slow-growth mode.
Japanese yields – which have been depressed for years due to deflation – have risen by about 1.3 per cent since last summer, to 1.7 per cent. More rises will follow if Japan’s emerging renaissance continues to ease fears of deflation.
In the U.K., whose economy was one of the first to see a recovery and where interest rates have already been hiked, bond yields have moved 1.3 per cent above their lows in the summer of 2003, to 5.2 per cent. In Canada, yields are up 80 basis points since March (or about 90 basis points since last summer), to five per cent, which means that there has been a modest narrowing of our U.S. spreads.
But it is the highly indebted emerging markets that have felt the most pain. Any rise in global interest rates raises issues about their ability to service foreign debts and leads to additional selling by bond holders. As a consequence, during periods of global financial stress or transition, emerging market bond yields tend to rise even more than U.S. yields.
Thus, Brazil’s bond market spreads over the U.S. have widened by more than two per cent this year, and Peru’s and Turkey’s have widened by 160 basis points. Argentina’s spreads have narrowed, but they are still huge.
The good news is that these spreads widened much more in early May, and then narrowed as markets became more used to the idea of rising interest rates.
For example, Brazil’s spread was four per cent in January, it widened to six per cent in March and then briefly to eight per cent in early May, but it is now back down to just over six per cent.
This pattern underscores two things: First, markets almost always over-react to new information, and then recover after a bout of indigestion; and second, the economic news from developing economies has been uniformly good recently, beating most economists’ forecasts, which means higher interest rates pose less of a threat to debt-service ability.
The bottom line? Markets are digesting a normalization of interest rates, and some indigestion is inevitable, particularly in certain developing economies.
Most bond markets are taking the news well, so far – certainly better than in 1994 – a tangible benefit of this low-inflation environment.
(Stephen Poloz is senior vice-president and chief economist for Export Development Canada. He can be reached at spoloz@edc.ca)
