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Hopeful bond sellers should strike while the iron is hot

by Teruhiko Mano

Long-term interest rates are on an upward trend both in Japan and the United States. The yield on the 10-year Japanese government bond has recently been in the 1.5 percent range, while market rates on 10-year U.S. government bonds have been hovering at around 5 percent — the same as at the beginning of 2001 — despite the 11 cuts the Federal Reserve Board has made to short-term interest rates over the past year.

There are various factors behind this trend, but long-term interest rates are obviously not rising in anticipation of a recovery in the two economies. For its part, the Bank of Japan has already explored most of the monetary measures available to it.

In the U.S., President George W. Bush clearly said at the beginning of his State of the Union address, “Our nation is at war, our economy is in recession.” FRB Chairman Allan Greenspan has also not changed his downward bias over short-term interest rate policy. Participants in the Group of Seven meeting over the weekend emphasized bright signs in the global economy, but the G7 statement should be taken as an indication of the expectations of the world’s financial authorities. Downward risk has not been ruled out.

In addition to the final settlements that will be taking place at the end of March — a short-term factor — there are two fundamental reasons behind the recent rises in long-term rates.

First of all, central banks’ efforts to ease their monetary policies have already reached their limit. Short-term rates in both countries have come down effectively to zero. It is impossible to push down the short-term rate further into the minus range. Market participants realize that interest rates will begin climbing in the future, although they do not know how soon.

Second, fiscal conditions in both countries are becoming worse. The fiscal 2002 Japanese government budget relies on issuing bonds worth 30 trillion yen, and if refunding bonds are included, total annual bond issuance is expected to hit 100 trillion yen. Accumulated public-sector debt is forecast to reach 670 trillion yen at the end of the fiscal year. Concern over a financial crisis and measures to deal with the mad cow scare may require the government to pump in additional spending.

The U.S. government is expected to post a $106 billion fiscal deficit for fiscal 2002 — the first deficit in five years — and is forecast to be in the red on a single-year basis through 2005. Further spending on antiterrorism measures or military expansion will put additional strains on the federal coffers.

In recent years, the surplus in the public sector has been making up for a lack of savings in the individual and corporate sectors.

But if the federal government goes into the red, the whole U.S. economy will be thrust into a savings shortage, which might put the nation further in debt in terms of the international balance of payments. In a year of midterm elections, such a situation could develop into trade friction and cause wild movements on the foreign-exchange market.

While higher interest rates hurt the real economy by increasing the cost of raising funds, some view them as a boon for individual savers or those searching for profitable investment tools. This may be partially true, but the matter is not that simple. Higher interest rates will have a negative impact in stock terms, because higher rates push down the prices of bonds and securities owned by the investors. Falling prices mean a decline in asset value. The larger the assets, the bigger the impact.

Therefore, the proper management of bond investments will take on rising importance in the future. I would like to mention two points in this respect.

First, bond holders will be inclined to sell to eliminate the risk of incurring a capital loss on their holdings, while buy orders may be hard to find when long-term interest rates are forecast to rise. This could lead to a vicious cycle of declining prices and rising interest rates.

Second, the bond market tends to look in only one direction.

While currency exchange rates will reflect relative valuation of the economic conditions and risks of the countries involved, a variety of factors impact them, and market watchers’ views tend to diverge.

Stock markets, meanwhile, are determined not only by macroeconomic estimates but also by factors specific to each issue. Those in the bond market, on the other hand, tend to look in the same direction when forecasting a nation’s interest rate trend. Although they may disagree on the timing and extent of coming changes, they tend to take one-way action that sometimes results in wild price fluctuations and few transactions.

The central bank may be able to adjust short-term interest rates, but long-term interest rates are determined by market forces under such conditions. It may be too late by the time you realize the risks.

As the stock market slump continues, there are reports that funds are shifting to the bond market. As the traditional saying goes, “Not yet” can mean “Already.” Quick action is necessary while there are still buyers on the market.