The Makings of a Bond Debacle

Among central bankers, there is agreement on the recipe for restoring stable, steady global growth. Step 1: Emerging-market central banks raise rates enough to put a lid on inflation. That supposedly prevents price pressures from spreading to the U.S. and gives the American economy more time to recover. Then, after interest rates in emerging markets have been set, it's time for Step 2, with the U.S. Federal Reserve tightening rates. As with a delicate soufflé, timing really matters. If it's off, the whole thing can collapse into an unappetizing mess.

That possibility is making some economists queasy. They fret that central banks around the world will get their sequencing wrong and that the unpredictability of it all will spook the bond markets. Specifically, they are worried about the 1994 scenario. That year, the U.S. economy was overheating, and investors didn't believe the Fed was serious about fighting inflation. To convince them, the Fed powered into action, raising rates faster than the markets expected. By the end of the year, rates in the U.S. stood at 5.5 percent, up from 3 percent in January. When rates go up, bond prices go down. Bondholders, fearing further Fed action, sold big time. Ten-year Treasuries lost 12 percent, according to Bloomberg data, and global capital losses reached about $1.5 trillion that year. The jolt from higher rates contributed to Mexico's currency crisis and the bankruptcy of California's Orange County. U.S. growth slowed to 0.9 percent in the second quarter of 1995, from 5.6 percent the previous year.

JPMorgan Chase (JPM) Chief Economist Bruce Kasman warns that a 1994-style selloff in global bonds could occur as early as 2012 because, he says, emerging-market economies are not tightening as fast as they should. Kasman calculates that even with recent increases, benchmark rates in developing countries remain about 200 basis points below their 2008 average and, adjusted for inflation, will end this year near their recession lows. Underlying inflation levels, meantime, are moving higher, he finds. If central banks don't act quickly, they may not contain inflation at home, leading to high inflation globally.

Worse, emerging markets may end up raising rates steeply at the same time the Fed swings into action to cool off the U.S. economy. That would likely trigger a bond market collapse. The rate increases would make it harder for companies to find affordable capital and for consumers to get credit and shop, leading to a worldwide brake on growth.

"There is a recipe for disruptive dynamics in markets if policy adjustments have to gather steam in a synchronized way," says New York-based Kasman, a former official at the Federal Reserve Bank of New York. In other words, he's worried about that unappetizing mess.

Emerging-market bonds already are underperforming as their central banks "are seen to have fallen behind the curve" in beating inflation, Stephen Jen, a managing director at BlueGold Capital Management, told a London conference on Feb. 28. These bonds have lost about 1.2 percent of their value since mid-October in dollar terms.

Jim O'Neill, London-based chairman of Goldman Sachs Asset Management (GS), doesn't think developing countries have lost control of inflation yet. Still, he says, the yield on the 10-year U.S. Treasury note could "quickly" reach 5 percent, from 3.5 percent now, if global growth picks up faster than anticipated. "The biggest thing I worry about is a major selloff in bonds like 1994," he says.

While 17 of the 21 emerging countries that Kasman's team monitors are lifting rates—with Brazil doing so on Mar. 3—he says he's concerned they aren't acting fast enough. He estimates the average interest rate for these economies, weighted for gross domestic product, will end the year almost a percentage point below the August 2007 level of 7.1 percent, even with inflation and growth averaging about 6 percent. The countries are hesitating to tighten aggressively because they fear higher rates would choke expansion amid lingering weakness and geopolitical risks overseas, says Michala Marcussen, head of global economics at Société Générale.

A case in point: While China, the fastest-growing major economy, has raised its one-year deposit rate three times since mid-October, to 3 percent, consumer-price gains remain almost 2 percentage points higher. With inflation running at 5 percent, savers have no incentive to keep their money in the bank and every reason to spend. That means China's monetary policy stays stimulative rather than restrictive. At the same time, China has limited gains in the yuan against the dollar to support exports. A Bloomberg study in mid-February of the most recent data available showed 8 of 14 other Asia-Pacific economies, including India, were running negative real rates.

At Morgan Stanley (MS) in London, economist Manoj Pradhan estimates his weighted average global interest rate will climb just 70 basis points, to 3.5 percent, this year, as the Fed and Bank of Japan keep rates low. Accounting for inflation, the real global rate will inch above zero only in the final quarter, he calculates. That leaves central banks in developing nations with a small window to ensure price pressures don't "get away from them," he says.

These economies also could create problems beyond their borders. Developing markets wield greater sway over global rates now than in 1994 because their share of world GDP has almost doubled, to just over a third, according to the International Monetary Fund. Says Kasman: "As we saw in 1994, a long period of easy money does create excesses."

The bottom line: Economists believe that if emerging economies don't raise rates fast enough, the bond market could collapse, slowing the world economy.

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