U.S. Interest Rates: The Potential Shock Heard Around the World

IMF Blog, May 21, 2014

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A bumpy U.S. exit from unconventional monetary policy could cause a faster rise in U.S. long-term Treasury rates that transmits to other bond markets, affecting not only emerging markets but also other advanced economies.

The timing and management of the U.S. Fed exit from unconventional monetary policy is critical, as demonstrated by the financial market turbulence of May 2013.
The analysis summarized is drawn from the latest Global Financial Stability Report and examines a tail-risk scenario (a bumpy exit), not the baseline prediction.

During the last five episodes when 10-year U.S. Treasury rates rose rapidly, bond yields rose, on average:
- 73 basis point in Canada for every 100 basis point rise in the U.S. Treasury rate.
- 66 basis points in the United Kingdom for every 100 basis point rise in the U.S. Treasury rate.
- 60 basis points in Germany for every 100 basis point rise in the U.S. Treasury rate.
- 36 basis points in Japan for every 100 basis point rise in the U.S. Treasury rate.
A similar effect was observed for emerging market local-currency bond yields, especially during the selloff in 2013.

Bond yields were decomposed into:
- expected short rates (determined by expectations of central bank policy rates), and
- the term premium (compensation sought by investors for potential losses due to interest rate or inflation risk).
Findings:
- The term premium plays a key role in the transmission of U.S. shocks to other countries.
- Even if expected short rates differ across countries, term premia across countries were found to be highly correlated.
- The transmission of U.S. term premium shocks to other countries was highest for Canada, followed by the United Kingdom, Germany, and Japan.

Two possible explanations:
- Financial linkages:
- A “global price of risk” may lead investors to price term premium across advanced economy bond markets similarly through arbitrage.
- Bond markets of major advanced economies have become increasingly integrated over time.
- Economic linkages:
- The term premium charged by investors tends to fluctuate with the country’s business cycle: when the economy is doing well, the premium drops, and vice versa.
- When the U.S. economy does well, other countries with close economic ties to the U.S. also tend to do well, synchronizing business cycles and term premia.
These factors help explain stronger term premium correlations between countries with closer financial and economic ties (for example, Canada and the United States).

A bumpy U.S. exit could impact other countries through bond markets if investors demand higher term premia in the United States.
Even if central banks outside the United States can fully control expected short-term rates through forward guidance, a rise in the U.S. term premium could still put upward pressure on long-term bond yields in other economies, including major advanced economies.
For countries with highly leveraged balance sheets, a rise in long-term yields could:
- Put further pressure on the capacity to service debt.
- Create headwinds for growth.
These points underscore the importance of achieving a smooth exit from unconventional monetary policy in the United States.

Source: U.S. Interest Rates: The Potential Shock Heard Around the World — Serkan Arslanalp, Yingyuan Chen, May 21, 2014 (IMF blog).