As higher growth and inflation, together with Federal Reserve interest-rate hikes, have pushed Treasury yields higher, commentators have pointed to a changing US landscape.
Savers can now secure higher interest income; mortgage seekers face funding costs not seen for many years; investors can gain somewhat better portfolio diversification benefits by owning fixed-income securities; and for stock pickers, financials have benefited while home builders have been hit.
But in terms of systemic importance, these developments could pale in comparison to the effect of recent US interest-rate moves on the paradigm for determining rates in the advanced world. There are growing indications of a potential reversal in causality in the relationship between US and European financial conditions.
For quite a while, Europe’s ample liquidity has put downward pressure on US rates overall and contributed to what had been a notable flattening of the yield curve for Treasuries, including a spread between two-year and 10-year bonds that even fell below 20 basis points. But now, European monetary conditions can no longer contain the overall rise in US yields, and are being tightened by events across the Atlantic. This has implications not only for Europe, which hasn't yet adopted a sufficiently pro-growth approach, but also for the emerging world.
Over the last few weeks, yields on short-dated US bonds have risen to levels not seen for many years. This has been accompanied by two other notable developments: This time, the yield curve has tended to steepen rather than flatten. And internationally, rather than just widen the yield differential between US and benchmark German bonds to even more elevated levels (the spread for 10-year bonds topped 260 basis points at the end of last week), German yields have been pulled up more and, in the process, have broken some notable benchmarks (including an increase above minus 50 basis points for two-year securities).
This ongoing change in the yield regime makes sense because of a divergence between the US and Europe that has become more multidimensional. For example:
- US growth has accelerated, powered by both consumption and investment, while Europe has been facing stronger headwinds.
- Trade tensions, both direct and indirect, are less harmful to the US because of its more diversified and entrepreneurial economy, which is also less open to trade compared with European nations.
- The US is pursuing a significantly more expansionary fiscal policy.
- The Federal Reserve raised rates on Wednesday for the eighth time since December 2015, and the central bank could go beyond what markets expect.
- The stagflationary impact of higher oil prices is likely to be less pronounced for the US than for many other advanced countries. This has already led European Central Bank President Mario Draghi to signal his expectations for higher inflation.
- Without more determined pro-growth measures on the part of Europe, it is hard to see any of these trends easing soon. As a result, Europe could face a tightening of financial conditions that go beyond what the ECB was anticipating.
If current trends intensify, the change in outlook could even undermine the ECB's guidance for quantitative easing (including another reduction of purchases on Oct. 1 that would lead to the elimination of the security-buying program three months later). It would also undermine the bank's guidance for the first interest rate hike (the end of the summer). This increases the complexity of the policy challenges facing the ECB.
Although this theme of greater divergence is most directly applicable to advanced countries, the emerging world also has a stake in what seems to be a change in the international interest rate regime.
The combination of higher rates and possible dollar appreciation would place greater pressure on the fragile economies -- those with large funding needs, high short-term debt, big currency mismatches and vulnerability to renewed outflows of portfolio investment.
And the more they are disrupted, the greater the risk of unfavorable contagion for other emerging economies.
The answer to all this is not for the Fed to stop hiking or, even worse, for the US to come down to a lower growth path. Rather, Europe should move more boldly on pro-growth policies. Otherwise, the continent could be on the receiving end of a monetary tightening that the ECB would only be able to counter by incurring the risk of additional unintended consequences and collateral damage.
(Bloomberg)
