Asset markets around the world have responded to the "pause" in the US Fed's rate-hiking spree in a largely textbook fashion. Equities and bonds have rallied and the US dollar has fallen against the majors. The Indian ten-year bond yield, for instance, has moved move down to 8 per cent from a level of close to 8.40 per cent just over a month back.
Recent economic data coming out of the US have broadly justified Fed Governor Bernanke's decision to take a breather. US core consumer price inflation registered a remarkably tame 0.2 per cent (month-on-month) for July. Housing starts, an important bellwether of economic activity, fell sharply to their lowest level since November 2004.
This might sound cynical but I seriously believe that it is a good time to turn cautious when market movements fall too closely in line with the diktat of economic logic.
Current market trends could thus turn out to be ephemeral. As monetary policy-making has become increasingly "data-driven", markets have turned increasingly volatile. A couple of strong numbers on the US economy could easily turn market sentiment "bearish". Bond yields could tick up again and flows into the equity markets could thin.
Besides the possibility of upsets in the short term, I am also concerned about some of the medium-term risks for liquidity and interest rates.
Let me start with what I see as the most critical. Real interest rates may have gone up across the world in the last two years but they are way below levels that prevailed in the 1980s and 1990s.
With oil prices remaining high, the threat of inflation has not diminished substantially. If this persists, I would not be surprised if real yields climb up to the levels of the previous two decades. That could come on the back of few more rate hikes by the US Fed and other central banks.
Markets have, however, not priced this possibility adequately. The majority of bond traders are working on the assumption that policy rates will merely "normalise" and central bankers will stop hiking when a "neutral" rate is reached.
The experience of the 1970s needs to be borne in mind in this context. In that decade, central bankers gave growth priority over inflation and "accommodated" oil prices when they rose.
This led to a fundamental upward shift in price and wage expectations, which led to a couple of rather sharp price spirals. When oil prices rose in 1979, it took the aggressive interest hikes that the Fed Chairman Paul Volcker put in place (the Volcker shocks, as they are popularly known) to finally bring inflation under control.
If today's central bankers draw on the lessons of history, there is every possibility that they will not merely stop at the "neutral rate" but take policy rates higher.
Low interest rates of the last three years have also stemmed from some structural changes that could reverse going forward. Long-term rates, for instance, have dropped sharply because of reduced term premiums.
This is the compensation that bond-holders seek for locking up their money in long-term instruments. Term premiums have dropped because investors have actively diversified their asset holdings into long-term instruments.
The demand for long-term US bonds, contrary to popular belief, has not come entirely from central bank reserves. Private-sector flows into long-term US bonds have been robust, driven by the need for portfolio diversification.
Pension funds, apprehensive of running large asset-liability mismatches, have also driven up the demand for longer-term bonds.
The decline in term premiums would have been justified if there was a simultaneous improvement in public finances. However, government finances in the major industrialised countries (led by the US) have actually deteriorated quite dramatically.
This in turn has increased long-term risks associated with an increasing debt stock such as the possibility of monetisation of deficits and high inflation. Term premiums should go up, not down, under these circumstances. Once the markets begin to correct this anomaly, long-term rates are bound to move up.
In a recent paper ("Virtual Reality, ABM-AMRO Economic Focus," August 17), my colleague Robert Lind raises an interesting point on the "savings glut" hypothesis.
Rob argues that the surfeit of liquidity, which has kept global liquidity high, could actually stem from an investment "drought" rather than a savings "glut".
If investments start picking up in the so-called savings surplus economies, interest rates are likely to move up sharply. Let me take a concrete example. The OPEC countries have been running large current account surpluses (that have emerged on the back of rising oil prices), which they have been parking in paper assets in the US and Europe.
Anecdotal evidence suggests that investment activity has started picking up in a number of these economies and the quantum of surpluses available from this region might decline.
That, in turn, could push interest rates up further in the industrial world. Given the increased integration among global markets, this is bound to have knock-on effects on developing markets like ours.
Let me get to the bottom line then. I am making a case against construing the current break in the interest rate cycle as sustainable long-term equilibrium. The fact that the US central bank has chosen not to hike its signal rate should not obfuscate the fact that there are way too many imbalances in the global economy that are crying out for correction.
One way in which this correction is likely to work is through a rise in real and nominal interest rates significantly above the current levels. We should be prepared for that.
The author is chief economist, ABN Amro. The views here are personal