The major central banks are jacking up interest rates, which is usually bad news for bonds, worldwide. But global bond markets actually seem to be welcoming tighter monetary policies.
The U.S. Federal Reserve has raised interest rates three times, for a total of 75 basis points, since late June. More hikes are expected later this year. Many expected these rate hikes to be passed right through to long-term interest rates as well. But U.S. 10-year bond yields have actually dropped by over 50 basis points since the Fed began raising rates last June.
Similarly, the Bank of England has raised interest rates five times for a total of 125 basis points in the past year. Meanwhile, British 10-year bond yields have stayed in a narrow range, and are now a little below where they were before rates first went up.
As a consequence, rather than boosting rates along the entire yield curve, central bank actions are causing yield curves to flatten. A country’s yield curve is its spectrum of interest rates arranged from shortest to longest term. Typically, interest rates are higher on longer-term bonds, because investors willing to part with their money for longer periods usually get paid extra for doing so. This time, central bank tightening is causing some short-term convulsions in long-term bond markets, but then, after a period of indigestion, long-term rates are settling back down.
The reason? Low inflation and, more importantly, low future inflation risk.
In the U.S., for example, high energy costs pushed inflation from below two per cent to above three per cent last spring. But recent figures have been more tame, at 2.7 per cent. Excluding the volatile food and energy components, inflation bottomed in late 2003 at just over one per cent, rose during the first few months of this year to 1.9 per cent, and has since eased to 1.7 per cent. In the U.K., inflation is running at a modest 2.2 per cent. What this indicates is that higher energy costs are being absorbed, rather than sparking a surge in generalized inflation.
Or at least that is the perception, so far. What the markets seem to be telling us is that they are reassured that central banks are on the job, and believe them capable of preventing an inflationary breakout, even if the root cause is beyond their control, such as rising oil prices. Assuming this faith in central bankers remains intact, the whole process of moving short-term interest rates back up to neutral levels could conceivably have a very modest impact on long-term rates.
This would be good news for borrowers, and for the economy. Some developing countries and corporations have actually seen their borrowing rates drop while central bank rates have been rising. This is because developing-country and corporate-bond spreads against U.S. bond yields have both narrowed since Greenspan began raising interest rates last June, and in both cases are less than half what they were at the peak in market angst, back in October 2002.
The bottom line?
Central banks are acting to prevent a resurgence of inflation, and markets seem convinced of it. Such bond market resilience should translate into economic resilience, too – in other words, economic growth should be sustained in 2005 despite higher central bank rates.
(Stephen Poloz is senior vice-president and chief economist for Export Development Canada. He can be reached at spoloz@edc.ca)
