Weekly Update - Do we need to worry about rising rates?

Long yields edged up this week after a shift in tone by central banks. 10-year sovereign yields widened nearly 20 bp in few days to 1.5% in the US and near 0.15% in France. The rises follow more hawkish talk from central banks, led by the US Federal Reserve which hinted it could move policy back toward normal faster than previously thought, by either hiking policy rates (raising very short-term rates) or trimming their asset purchase programme (pushing up long-term yields). Patchy price pressures, notably on energy, are worrying monetary authorities, raising the spectre of a longer-term inflationary trend against the backdrop of continuing recovery in developed economies. For now, the Fed and Bank of England have stopped at tougher talk. But other central banks, such as the Bank of Norway, have acted by raising rates.

Rate rises likely to track the pace of economic recovery. We expect economic activity to remain strong over the next few quarters, particularly in the developed world, with labour markets getting back on track and still supportive financial and fiscal conditions. Such a scenario should pave the way for a normalisation of monetary policy and further upward drift in long-term yields. But rises will depend heavily on actual economic gains and be limited in scale whatever happens.

Rising long yields should not hamper equity markets. The rise in yields this week has been accompanied by turbulent equity markets. Volatility has spiked and valuations retreated. That said, we should not be reading higher rates as a negative signal. In fact, the key underlying driver is an improving economy, which should be good news for companies and hence stock markets. Also, the rise remains relatively modest. In real terms (stripping out the effects of inflation), interest rates remain historically low (see charts) and still providing significant support for household and corporate spending.

Bottom line.
This week's upsurge in long-term yields reflects a turning point for monetary policy and is likely to persist for some weeks. But the rises will not hurt equity markets as long as they essentially reflect the firming of economic recovery.

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