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

Emerging-market central banks risk triggering a “1994-style” sell-off in global bonds as soon as next year if they're still tightening monetary policy when the Federal Reserve begins raising interest rates. That's 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 finds. A reluctance to act faster means 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, 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 for Treasuries to slide more than 3 percent as policy makers 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 New York-based 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. Bonds get killed,” he said. ‘Behind the Curve' Central bankers from emerging and developed markets meet today in Basel, Switzerland, for talks at the Bank for International Settlements. They convene four 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-market 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, told a London conference on Feb. 28. Such securities have lost about 1.2 percent since mid-October in dollar terms, according to JPMorgan Chase's GBI-EM Index. Although he doubts developing countries are losing control of inflation, Jim O'Neill, the London-based chairman of Goldman Sachs Asset Management, says the yield on the 10-year U.S. Treasury note could “quickly” reach 5 percent 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 percent on March 4. Biggest Worry “The biggest thing I worry about is a major sell-off in bonds like 1994,” said O'Neill, who helps to manage about $840 billion. “The ideal situation is the developed world comes back as the developing world slows, but what could happen is as the U.S. and others strengthen, they give the developing world another growth kick.” The consensus forecast remains for a muted decline in U.S. Treasuries, with 10-year note yields rising to 4.25 percent in the second quarter of next year, according to the median estimate of 53 economists surveyed by Bloomberg News. Bill Gross, who runs the world's biggest bond fund at Pacific Investment Management Co., said in January that even though he anticipates the end of the bull market in bonds, there won't be a significant bear market. Gross 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 the central banks of Russia, India, China and Brazil soon will accelerate their rate increases, said Scott Minerd, chief investment officer at Guggenheim Partners LLC in New York. He notes 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,” Minerd said 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 Kasman's team monitors are lifting rates -- with Brazil doing so last week -- 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. Growth Concern These countries currently are sitting “behind the curve” because they fear higher rates would choke expansion amid lingering weakness and geopolitical risks overseas, said Michala Marcussen, head of global economics at Societe Generale SA in London. 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: While China, the fastest growing major economy, has raised itsone-year deposit rate three times since mid-October to 3 percent, consumer-price gains remain almost 2 percentage points higher. That's handing savers an incentive to buy goods and assets, meaning 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, although its influence is greater because it serves as a lynchpin for other emerging-market rates. A Bloomberg study in mid-February of the most recent data available showed eight of 14 other Asia-Pacific economies, including India, also were running negative real rates. Negative Rates At Morgan Stanley 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,” requiring them to intensify their policy tightening, he said. For now, they're 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,” Pradhan 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. Exporting Inflation 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 in New York, told Bloomberg Television March 1. The cost of goods the U.S. imports from China rose 0.3 percent in January, according to the Labor Department. International policy makers may end up boosting interest 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, saidPiero Ghezzi, head of global economics, emerging markets and currency research at Barclays Capital in London. His colleagues predict the Fed will begin raising ratesfrom near zero in August 2012. Simultaneous Moves “Synchronized rate increases are always bad for global growth and markets,” Ghezzi said. “My fear is many central banks will have to play catch-up.” Policy makers aren't in a hurry to tighten for now because they currently prize financial stability over price stability, said Thomas Mayer, Frankfurt-based chief economist at Deutsche Bank AG. He projects global inflation soon could reach as high as 6 percent, with emerging markets nearing 10 percent. The last time the world experienced such pressures was in 2008, when they were thwarted only by the credit crisis and recession, he said. This time, central banks will allow inflation to run, Mayer said. They will nevertheless try to cap long-term bond yields by pledging to keep interest rates low, avoiding a repeat of 1994, he said. He noted that even with inflation in the U.K. at 4 percent in January, the 10-year government note yielded about 3.6 percent last week. “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 and is what happened in 1994,” Mayer said. Back then, the Fed lifted the rate banks charge each other on overnight loans three times, in 25 basis-point steps. Policy makers then executed two half-point moves before a 75 basis- point increase that took it to 5.5 percent at year-end. Treasuries lost 3.3 percent, 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 percent in the second quarter of 1995 from 5.6 percent a year earlier. “As we saw in 1994, a long period of easy money does create excesses in financial markets,” Kasman said. --Bloomberg News--