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.