NEWS / Foreign Exchange

Real long-term interest rates must rise

Summary

??? Several regions of the world are seeing nominal GDP growth rates that are far higher than the long-term bond yields in their local markets. Examples include the euro zone, emerging Asia and the United Kingdom.

??? Current global monetary policy is not totally reassuring. Despite synchronized tightening by the world??™s principal central banks, long-term bond rates are too low relative to economic growth.

??? World liquidity has not dried up fast enough and financial conditions remain too loose. If this continues, inflation risks heating up.

??? For long-term price stability to be maintained, financial markets will need to restore real long-term rates to adequate levels (in line with economic growth). Or else central banks will be forced to lead the way.

What has gotten into the central banks?

Several of the world??™s central banks continue to tighten the screws. The Reserve Bank of New Zealand recently raised its key rate to 8%, its highest level since 1998. The United Kingdom??™s central bank has hiked its intervention rate to 5.5% and the European Central Bank has just moved again, raising its policy rate to 4%. What has gotten into the  central banks?

Helped by the low real interest rates (in fact possibly too low) that markets are building into long-term bonds, it appears that the financial conditions underlying the world economy remain too accommodating, this, despite the recent policy rate hikes by several central banks.

Real-long term bond rates on the financial markets need to get back to normal. If they don??™t, the central banks will need to show the way.

Another turn of the screw

Judging from the recent series of policy rate hikes, nervousness appears to be engulfing some of the world??™s central banks. As we shall see, there is good reason for this. That the key rates of an increasing number of central banks are approaching the cyclical peak levels that were last hit during the year 2000 is far from a coincidence.

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