Global Bonds Can Stand Fed Hikes

If the Federal Reserve lifts U.S. interest rates in 1997, as the Organization for Economic Cooperation & Development forecasts in its latest semiannual outlook for 29 member countries, will the hike bring turmoil to global bond markets? That happened when the Fed tightened in 1994, and bond yields outside the U.S. soared though economic fundamentals hardly justified their surge. If that were to happen in 1997, the fragile recoveries in Europe and Japan would be at risk.

While the OECD believes that interdependencies among global financial markets have increased, it argues that a repeat of the 1994 debacle is unlikely. First, the Paris-based think tank says that globalization has helped to ease bond-market synchronization, because exchange rates now absorb more of the pressures that can result when interest rates diverge.

Second, any U.S. tightening is likely to be on a smaller scale than in 1994, says the OECD, because real policy rates were much lower then. Also, given uncertainties about recoveries in Europe and Japan, global demand for capital is unlikely to spike up, as was the fear in 1994. The Bank of Japan will be able to keep short-term rates low without fear that inflation will pick up, keeping the upward pressure off Japan's long-term rates.

Underlying all this is the OECD's forecast for moderate world growth in 1997 of 2.4%, the same as in 1996, rising to 2.7% in 1998 as recoveries in Europe and Japan strengthen. The forecasters see little threat of inflation, though they suggest that situations in Britain and the U.S. bear watching. The OECD says the generally low risk of inflation offers the chance for interest-rate cuts, especially in Continental Europe where efforts to cut public spending are braking economic growth and keeping joblessness high.

If the OECD is right, a divergence in monetary policies in the U.S. vs. those in Japan and Europe would result in a strong dollar, but it would not wreak havoc in the global bond markets.

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