Financial forecasters confident the dark clouds will pass

PUBLISHED : Thursday, 30 June, 2005, 12:00am
UPDATED : Thursday, 30 June, 2005, 12:00am

If on the previous six occasions you heard thunder a violent rainstorm had followed minutes later, then at the next thunderclap you would probably take shelter.

Well, what is going on - more or less - in international financial markets at the moment is that dark clouds are gathering and there is an ominous rumbling in the distance, yet investors are not even reaching for their umbrellas.

The rumbling is coming from long-term interest rates. At its meeting today, the United States Federal Reserve is universally expected to raise short-term interest rates for the ninth time in a row, pushing its benchmark overnight rate up to 3.25 per cent from just 1 per cent a year ago.

With a little nudging from the Hong Kong Monetary Authority, local short-term rates have duly followed US rates. Yesterday the three-month Hong Kong interbank offered rate stood at 3.35 per cent, up from just a hair's breadth above zero last year.

But while short-term rates have been heading higher, long-term interest rates have been falling. Undeterred by rising short rates, investors have continued to buy bonds, pushing prices up and yields down. From a high of 4.89 per cent in June last year, the yield on 10-year US treasury notes has sunk to 3.96 per cent.

Similarly in Hong Kong, yields on equivalent Exchange Fund notes dropped from 4.93 per cent to 3.56 per cent yesterday.

In other words, the yield curve - the series of interest rates earned across different maturities - has become much flatter. A year ago, the difference between US overnight and 10-year rates was 3.89 percentage points. Yesterday, it was just short of one percentage point. After today's Fed meeting it is likely to be even smaller, about 0.7 of a percentage point.

Market watchers increasingly expect the difference to vanish altogether and for the yield curve to invert, with long-term interest rates falling below short-term rates.

Normally that would be the signal to run for cover. The last six times the US dollar yield curve has inverted, a recession has followed in America within 18 months.

That would be bad news for Hong Kong's economy. America remains the biggest market for Hong Kong's domestic exports, and is Hong Kong's second-biggest trading partner overall. A contracting economy in the US would certainly dampen growth here and could even lead to local recession.

Happily, many forecasters, including Fed chairman Alan Greenspan, are arguing that the thunderclap will prove to be a false alarm.

Pundits have advanced a range of explanations for why an inverted yield curve will not indicate a recession on the way. Some believe bond yields have been artificially depressed by Asian central banks, which have been heavy buyers of US treasury debt. Others say the distortion is caused by pension funds switching their assets from volatile equities into safer bonds as investors approach retirement.

Last week, researchers at JP Morgan in London suggested another possible reason. While they acknowledge the role of Asian central banks, they say a global savings glut driven mainly by a dramatic increase in corporate savings is responsible for pushing long-term interest rates down.

Between 2000 and last year, companies in the world's developed economies saved more than US$1 trillion, as they scaled back their borrowing and investment following the technology bust and repaired their balance sheets. According to JP Morgan, that saving has knocked 0.7 percentage point off inflation-adjusted bond yields.

The good news is that companies have recently started to borrow and invest once again. In the US and Japan, demand for commercial loans turned positive late last year, which JP Morgan's analysts say will help push long-term interest rates back to more normal levels over the next year or so.

If they are right, you can leave your umbrella at home.