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

_IMF Blog, May 21, 2014_

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## Bibliographic details
- Authors: Serkan Arslanalp, Yingyuan Chen
- Published: May 21, 2014

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### Key takeaway
- 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.

### Context and motivation
- 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.

### Some facts (historical evidence)
- 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.

### Transmission mechanism: the term premium as a key channel
- 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.

### Why term premia are correlated across countries
- 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).

### Implications and policy-relevant points
- 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).*

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## References

- [analysis](http://blogs.imf.org/2014/04/09/global-financial-stability-beginning-to-turn-the-corner/)
- [Global Financial Stability Report](http://www.imf.org/External/Pubs/FT/GFSR/2014/01/index.htm)
- [https://www.imf.org/wp-content/uploads/2014/05/figure-13.jpg](https://www.imf.org/wp-content/uploads/2014/05/figure-13.jpg)
- [https://www.imf.org/wp-content/uploads/2014/05/figure-22.jpg](https://www.imf.org/wp-content/uploads/2014/05/figure-22.jpg)
- [https://www.imf.org/wp-content/uploads/2014/05/figure-32.jpg](https://www.imf.org/wp-content/uploads/2014/05/figure-32.jpg)

_Source: https://www.imf.org/en/blogs/articles/2014/05/21/u-s-interest-rates-the-potential-shock-heard-around-the-world_