Economists are dubbing it "the great rate debate."
Soaring interest rates in the bond market in recent weeks have investors wondering whether global central banks could begin raising their trendsetting interest rates ahead of schedule.
Rate hikes were unthinkable only a month or two ago. But a string of "less negative" consumer and employment data, combined with rising stock and commodity prices, serve as harbingers of an economy on the mend. Meanwhile, bond traders are fixating on the threat of inflation as governments issue massive amounts of debt to jump-start growth, while concerns swirl about the security of the United States' prized AAA credit rating.
The confluence of those factors has spurred a sharp run-up in longer-term bond yields in recent weeks, as the market wagers that central banks will be forced to hike interest rates in order to control inflation.
Rising rates would put more strain on consumers by driving up the cost of variable-rate mortgages, lines of credit and other loans, and some economists worry the trend could muck up an economic recovery before it takes root. Already, mortgage rates in Canada and the U.S. have jumped. Typical five-year fixed-rate loans are around 5.85 per cent in Canada, up about 60 basis points in about a week.
Some experts, however, argue that bond yields are due for a correction. The bond market enjoyed a rare strong session yesterday as investors attracted to the higher interest rates bid up bond prices and pushed yields downward. But it's too soon to tell whether the dip in yields marks the beginning of a meaningful pullback.
"The main reason why average Canadians should care about a rise in bond yields is that ultimately, it raises borrowing costs," said Craig Alexander, deputy chief economist at TD Bank Financial Group. "And higher borrowing costs during a period of economic weakness will act as a headwind in terms of how strong the economic recovery is."
Alexander doubts the recent rise in yields is sufficient enough to jeopardize the recovery, but he remains "concerned" because the trend has already resulted in higher longer-term mortgage rates in both Canada and the United States.
Bond market action suggests that various floating-rate loans could be on the rise in the near future. The prevailing sentiment sees the U.S. Federal Reserve increasing its key interest rate by the end of this year, putting more pressure on the Bank of Canada to follow suit.
For his part, governor Mark Carney reiterated plans yesterday to keep Canada's overnight rate at a record low of 0.25 per cent until mid 2010, provided inflation remains tame. Economists, meanwhile, argue the bond market is being too hasty.
"Expectations of a (Fed) rate hike in 2009 may be premature even though the economic outlook is brightening," wrote Benjamin Reitzes of BMO Capital Markets in a report. He noted the U.S. economy continues to shed jobs, while real gross domestic product has yet to bottom out. "With consumers accounting for 70 per cent of the economy, real GDP growth is likely to remain lacklustre through 2010, relative to previous recoveries."
Nonetheless, there were more indications the worst of the crisis may have passed. U.S. retail sales rose in May for the first time in three months, while a separate report showed claims for jobless benefits fell last week.
Economists warn that higher interest rates too soon would hurt consumer spending on both sides of the border, especially on big-ticket items that require financing, such as furniture, appliances, automobiles and homes.
"Markets don't travel in a straight line. So, at some point, I think, there is going to be a bit of a reappraisal," Alexander said. The timing, however, remains sketchy despite yesterday's rally.
U.S. Treasury prices rose yesterday, pulling benchmark yields back from eight-month highs above 4 per cent, as a solid auction of 30-year debt assuaged worries over America's rising budget deficit.
The $11 billion (U.S.) sale was the first reopening of a 30-year issue since the government announced in April that it was moving to monthly sales of long bonds.
The sale appeared to benefit from a steep sell-off in recent days that made bond prices more attractive.
This week has also been the first test of the government's long-term borrowing ability since investors began to question the United States' AAA credit rating last month.
A 10-year auction on Wednesday met with spotty reception and raised some concerns, but the 30-year sale followed up strongly, leaving some fixed income investors heartened.
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