John Rapley writes that the war in Iran may prod central banks to raise rates to fight the inflation it has worsened.Adrian Wyld/The Canadian Press
John Rapley is a contributing columnist for The Globe and Mail. He is an author and academic whose books include Why Empires Fall and Twilight of the Money Gods.
Throughout the Iran war, stock markets have rallied and oil has remained relatively subdued, rising much less than analysts feared would happen once the Strait of Hormuz was closed. The bond market has regularly tut-tutted this complacency, expressing disapproval if not outright alarm. But over the past two weeks, the patience of bond investors finally snapped and prices plunged.
The value of a bond at maturity is fixed when the government sells it. Since those bonds can subsequently be traded on secondary markets, when their prices fall, the effective rate of return rises. And that means that when the government sells new bonds, it must improve its offer.
Thus, investors are effectively forcing interest rates higher, with the increase being particularly stark over the past week. No single event triggered the wave of selling. Britain’s leadership crisis raised the prospect of looser fiscal policy, Japan’s new government is spending lavishly, U.S. President Donald Trump is pressing the incoming Federal Reserve chairman to cut interest rates, the Iran fiasco has driven up inflation and the Beijing summit, which the United States had briefed might reopen the strait, ended up a damp squib.
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But underlying all these developments is a fundamental, common cause: The debts of Western governments have risen sharply, and now look set to continue doing so. Investors, worried there’s no end in sight, are thus demanding higher payments for the money they lend to governments, since they think those governments might try inflating their way out of debt.
Until recently, investors had been willing to believe the pledges by governments that their borrowing increases would be only temporary. However, the Iran war may have tipped a delicate equilibrium between them out of balance.
The war may prod central banks to raise rates to fight the inflation it has worsened. And by so forcing consumers and businesses to tighten their belts to cover higher credit costs, it could slow the economy. That in turn would reduce tax revenues and increase stimulus expenditure. All told, debt could spiral upward.
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Of particular concern is what’s happening in the U.S. and Japan. The U.S. national debt is rising by the day, and interest rates on U.S. Treasury bonds have risen by over a quarter of a percentage point in just the past month. Being the world’s largest and most liquid bond market, rising American interest rates lure investors from all over the world. As those investors consequently reduce their purchases of their own countries’ bonds, rates then rise closer to home. Thus Canada, whose bonds have so far remained relatively steady, is nonetheless seeing interest rates go up.
Japan’s increase has been ever more dramatic, with rates there up a third of a percentage point in the past month. That matters to us all because Japanese investors own a lot of other countries’ bonds. For years, the Bank of Japan’s ultraloose monetary policy kept interest rates near zero, which encouraged Japanese investors to borrow for next to nothing, then invest it abroad. Now that interest rates are rising rapidly in Japan, a wave of repatriation of that money may begin, which would further drive down bond prices elsewhere.
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Ordinarily, bond and stock prices move together. When interest rates rise, investors sell stocks to buy bonds, attracted by a dividend on a security which, backed by the government’s power to issue money, is the safest investment around. So far, though, there’s been little sign of stress in stocks. That may be because while the rise in interest rates has been rapid, today’s levels are not high by historical standards. In fact they’re only now returning to where they were on the eve of the 2008 financial crisis.
But that itself may be ominous. The past 15 years have been a period of ultracheap credit, which fuelled investment booms that drove stock and property prices to the moon. Many mistakenly took this to be a permanent state of affairs. It may be only now that we’re returning to normality.
If what buoyed house and stock prices was an endless supply of cheap credit, the return to more normal rates of interest could choke that off. In Canada, a floodtide of cheap credit made many property owners wealthy. Now that the tide is reversing, the reckoning may only have begun. Real estate markets are already feeling the pain in Canada and the U.S. Whether stocks can continue to ignore it remains to be seen.