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S. Balakrishnan

WE are in the era of single-digit interest rates. A glance at the G-7 countries shows that in none does the central bank rate exceed 5 per cent. Japan continues with its zero rate policy and the European Central Bank is at 2 per cent (with the prospect of a slight increase in the near future). Till mid-2004, the US rates were 1 per cent.

Low central bank rates co-exist with low bond yields. Ten-year Japanese Government bonds offer about 1.5 per cent; German bonds return 3.5 per cent. In the US, despite a punishing increase of 3 per cent in the Fed Funds rate in less than 18 months, 10-year bonds yield only 4.5 per cent.

What's going on? Does the market think central banks have finally conquered inflation? Or are low long-term rates a harbinger of a global economic slowdown?

Bonds remain completely unfazed even as inflation has ticked upwards. Any increase in price levels is seen as temporary, due to one-time factors such as high-energy prices.

A lot will depend on the global economic outlook for 2006. Forecasts, as usual, diverge, but none is talking of any boom on the horizon.

Pessimists like Mr Bill Gross, manager of the US' largest bond fund, think that the Fed will start cutting rates next year, in response to a slowing economy.

Do the doomsayers have a case? Instead of the US, for a change, start with China and India. Start not with the US, but for a change, with China and India. Both economies show no let-up in momentum. Barring event risk (and recent experience indicates setbacks from major unexpected catastrophes are extremely short-lived), their growth picture is bright. And just as a rising tide lifts all boats, this should spill over to the rest of the world. After all, both are becoming economic giants and will provide sufficient traction for everyone.

In fact, a survey of German manufacturers showed a high degree of optimism about prospects. Where does it stem from? Surely not business from the mature economies of the West, but emerging markets.

With economic activity likely to rise the argument for bond yields staying low are looking weak. Inflation will remain in a range. But the threat of a rise will be ever-present, adding a premium to yields for inflation risk.

More important is the rise in credit demand from increasing consumption and investment, especially in the BRICS (Brazil, Russia, India, China and South Africa) group, which should fuel growth in other parts of the world as well.

While the Fed may well be in `pause' territory, that is unlikely to keep bond yields soft. They will have only one way to go — up.

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