Bonds could 'get killed' in coming months, warns bank economist

Emerging-markets central banks risk triggering a “1994-style” sell-off in global bonds as soon as next year if they are still tightening monetary policy when the Federal Reserve begins raising interest rates. That is the warning of JPMorgan Chase & Co. chief economist Bruce Kasman, who 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 also are moving higher, he said. A reluctance to act faster means that the central banks of these economies ultimately may fail to contain inflation at home while fanning it abroad, leaving themselves and the Fed toughening monetary policy at the same time, Mr. Kasman said. His fear is that simultaneous shifts will lead financial markets to echo 1994, when investors first doubted the Fed's inflation-fighting mettle, only to see Treasuries slide more than 3% as policymakers almost doubled the federal funds rate. “There is a recipe for disruptive dynamics in markets if policy adjustments have to gather steam in a synchronized way,” said Mr. Kasman, a former official at the Federal Reserve Bank of New York who now oversees economic research at the second-largest U.S. bank by assets. Such a scenario could develop in 12 to 36 months and would “take a toll on risk assets,” he said. “Bonds get killed,” Mr. Kasman said.

'BEHIND THE CURVE'

Central bankers from emerging and developed markets met last week in Basel, Switzerland, for talks at the Bank for International Settlements. They convened days after European Central Bank President Jean-Claude Trichet surprised investors by saying a rate increase in the euro area is “possible” next month, pushing German two-year notes to their second weekly drop. Emerging-markets bonds already are starting to underperform and will continue to do so amid speculation that their central banks “are seen to have fallen behind the curve” in beating inflation, Stephen Jen, a managing director at BlueGold Capital Management LLP, said at a conference in London Feb. 28. The securities have lost about 1.2% since mid-October in dollar terms, according to JPMorgan Chase's GBI-EM Index. Although he doubts that developing countries are losing control of inflation, Jim O'Neill, the chairman of Goldman Sachs Asset Management, said that the yield on the 10-year U.S. Treasury note could “quickly” reach 5% if global growth is allowed to pick up faster than anticipated, forcing the Fed to start normalizing policy. The interest rate on the benchmark U.S. security was 3.49% on March 4. “The biggest thing I worry about is a major sell-off in bonds like 1994,” said Mr. O'Neill, who helps manage about $840 billion. The consensus forecast remains a muted decline in Treasuries, with 10-year note yields rising to 4.25% in the second quarter next year, according to the median estimate of 53 economists surveyed by Bloom-berg News. Bill Gross, co-chief investment officer of Pacific Investment Management Co. LLC, said in January that even though he anticipates the end of the bull market in bonds, there won't be a significant bear market. He has cut his holdings of government-related debt to the lowest level in two years.

FOOD, OIL COSTS

The recent surge in food and oil prices also means that the central banks of Brazil, Russia, India and China soon will accelerate their rate increases, said Scott Minerd, chief investment officer at Guggenheim Partners LLC. He noted that China is the world's second-largest consumer of crude, which is now trading above $100 a barrel. Global food prices reached a record in February, according to the Food and Agriculture Organization of the United Nations. The BRIC economies “need to take dramatic policy measures to cool off overheating markets and fight inflation,” Mr. Minerd wrote in a March 1 report. “Restrictive monetary policy will lead to economic slowdown” in the developing world. Nevertheless, while 17 of the 21 emerging countries that Mr. Kasman's team monitors are lifting rates — with Brazil doing so two weeks ago — he said that he is concerned that they aren't acting fast enough. He estimated that 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%, even with inflation and growth averaging about 6%.

GROWTH CONCERN

These countries are sitting “behind the curve” because they fear that higher rates would choke expansion amid lingering weakness and geopolitical risks overseas, said Michala Marcussen, head of global economics at Société Générale SA. Even higher rates relative to the developed economies also risk luring more speculative capital and pushing up currencies to the detriment of exports, she said. A case in point: Although China, the fastest-growing major economy, has raised its one-year deposit rate three times since mid-October to 3%, consumer price gains remain almost 2 percentage points higher. That is handing savers an incentive to buy goods and assets, meaning that monetary policy stays stimulative rather than restrictive. At the same time, China has limited gains in the yuan against the dollar, supporting exports. China isn't alone, though its influence is greater because it serves as a linchpin for other emerging-markets rates. A Bloomberg study last month of the most recent data available showed that eight of 14 other Asia-Pacific economies, including India, also were running negative real rates. Morgan Stanley Smith Barney LLC economist Manoj Pradhan estimates that his weighted average global interest rate will climb just 70 basis points to 3.5% 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 said. That leaves central banks in developing nations with a small window to ensure that price pressures don't “get away from them,” requiring them to intensify their policy tightening, Mr. Pradhan said. For now, they are trying to preserve growth and stabilize, rather than slash, inflation, which may mean “they tolerate inflation too much and have to speed up the interest rate process later,” he said. They also could create problems beyond their borders. Developing markets wield greater sway over global pricing power now than in 1994 because their share of world GDP has almost doubled to just over a third, according to International Monetary Fund data. At the same time, China is becoming an “exporter of inflation” rather than deflation as labor costs rise, David Woo, head of global rates and currency research at Bank of America Merrill Lynch, told Bloomberg Television on March 1. The cost of goods the U.S. imports from China rose 0.3% in January, according to the Labor Department. International policymakers may end up boosting rates in lock step rather than in line with the demands of their own economic cycles, squeezing the global recovery by limiting the scope for countries to power growth through exports, said Piero Ghezzi, head of global economics, emerging markets and currency research at Barclays Capital. His colleagues predict that the Fed will begin raising rates from near zero in August 2012.

SIMULTANEOUS MOVES

“Synchronized rate increases are always bad for global growth and markets,” Mr. Ghezzi said. Policymakers aren't in a hurry to tighten, because they prize financial stability over price stability, said Thomas Mayer, chief economist at Deutsche Bank AG. He said that global inflation soon could reach 6%, with emerging markets nearing 10%. The last time the world experienced such pressures was in 2008, when they were thwarted only by the credit crisis and recession, Mr. Mayer said. This time, central banks will allow inflation to run, he said. They will nevertheless try to cap long-term-bond yields by pledging to keep interest rates low, avoiding a repeat of 1994, Mr. Mayer said. He noted that even with inflation in the United Kingdom at 4% in January, the 10-year government note yielded about 3.6% two weeks ago. “Central banks may be behind the curve, but I can't see them trying to get ahead of it,” which “can create problems for bond markets,” Mr. Mayer said. Back then, the Fed lifted the rate that banks charge each other on overnight loans three times, in 25-basis-point steps. Policymakers then executed two half-point moves before a 75-basis-point increase that took it to 5.5% at year-end. Treasuries lost 3.3%, according to data from Bank of America Merrill Lynch, and global capital losses reached about $1.5 trillion that year. The transition to higher rates played a part in the Mexican currency crisis and the bankruptcy of California's Orange County. U.S. growth slowed to 0.9% in the second quarter of 1995 from 5.6% a year earlier.