Interest rates are moving higher in both the United States and China — the big difference of course, is that in China, it’s the central bank that’s raising rates, whereas in the US, inflation worries are writ large in the bond market.

Last night, China’s central bank, the People’s Bank of China, struck again, announcing a further 0.25 percentage point increase in interest rates — the third increase in four months. The bank is hoping that by nudging up rates, it will be able to take some steam out of an overheating economy, without causing it to slow too sharply.

In contrast, the US central bank is worried that underlying inflation remains too low. As a result, it’s running an ultra-loose monetary policy by keeping interest rates close to zero indefinitely, and injecting extra liquidity through its $US600 billion bond buying program, popularly known as QE2.

But bond markets are worried this ultra-loose monetary policy, combined with the US government’s massive budget deficits, will eventually result in an inflationary outbreak in the US. As a result, bond yields are rising sharply, as investors demand a bigger reward to compensate them for the inflation danger. The yield on benchmark 10-year bonds climbed 0.3 percentage points and they are now trading at a nine-month peak of 3.7%. Some investors fear that bond yields will move even higher as soaring commodity prices — particularly for food and fuel — start showing up in official US inflation figures.

David Rosenberg, chief economist at Gluskin Sheff, says that so far the increase in bond yields has been about four parts — “real rate” driven, and one part “inflation” driven.

“The real rate adjustment reflects the improvement we have seen in the real economy as well as heightened risk appetite among investors,” he said. “But we have had, nonetheless, a situation where food costs have surged at a 60% annual rate since last Fall and energy prices at a 45% annual rate. Considering that food and fuels make up 23% of the CPI, it would stand to reason that we are going to be seeing some pretty big headline numbers coming soon, even if the grocery chains come close to fully passing on these costs to consumers.”

He points out that the yield on 10-year bonds last climbed to 4% in early April last year, which ushered in a period of share market weakness.

This time around, not only are bond markets worried about big US budget deficits and ultra-loose monetary policies, but they’ve got the additional worry of higher inflation caused by surging commodity prices. And there is evidence that firms are passing higher energy and raw material costs on to consumers.

“The reason why we cannot rule out +0.3% for the core CPI or perhaps even a couple of nasty, even if brief reports, is that airlines are passing on the fuel costs and we know that apparel retailers will soon pass on the cotton-induced price increases,” he writes. “Moreover, unlike a year ago, the rental components of the CPI are no longer decelerating. This does pose a bit of a near-term problem because the best leading indicator of core goods CPI is the core intermediate PPI and it has risen now by 0.3% or more for four months in a row and at an annual rate of around 6%.”

As Rosenberg points out, higher inflation figures will come as a shock to both bond and equity markets because they will make it much more difficult for the US central bank to justify extending its bond-buying program past its expected expiry date in June. At present, equity markets are soaring because many investors assume the US central bank will launch a new bond buying program — already dubbed QE3 — when the present one expires.

“Imagine what printing a couple of 0.3% on core CPI in coming months will do to QE3 prospects — seriously damage them is what — at a time when 40% of market participants already believe that this is baked in the cake,” Rosenberg warns.

*This article was originally published on Business Spectator

Peter Fray

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