Volatile US Bond Market a Major Risk for Global Economy: OECD

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While growth in the U.S. will likely outpace major developed markets in the coming months, according to the Organization for Economic Co-operation and Development (OECD), it warned potential instability in the country's bond market arising from a tapering of quantitative easing (QE) poses a major threat to the outlook for the global economy.

"Exit from unconventional monetary policy may be difficult to manage and less smooth than desirable, possibly leading to sharp rises in bond yields and serious negative consequences for growth in a number of advanced and emerging economies," Pier Carlo Padoan, deputy secretary-general and chief economist at OECD wrote in its latest economic outlook published on Wednesday.

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"If yields increase strongly or abruptly, for instance due to investors being surprised by the timing or pace of policy changes, or if higher interest rates expose vulnerabilities in the financial system, it could be disruptive," he added.

The yields on U.S. government bonds have been moving upwards in the past month on speculation the Federal Reserve may scale back its monthly bond purchases in the next few meetings. Treasury yields rose to their highest levels in over a year on Tuesday, with the 30-year yield climbing to 3.331 percent.

A swift rise in U.S. government bond yields would result in capital losses for investors and other assets would likely follow suit, with mortgage-backed securities and corporate bonds the most heavily impacted, according to OECD. A one-percentage point increase in a 10-year zero-coupon bond yield would reduce its price by around 9 percent, according to the organization's calculations.

"Unless offset by portfolio shifts as investors move funds from bonds to equities, the higher long-term interest rate would weigh on equities, and property valuations could also be marked down," it said.

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Increased U.S. bond yields would also have a negative impact on growth in other developed economies too through trade and financial market linkages. The organization estimates a 2 percentage point rise in U.S. long term interest rates over one year would reduce gross domestic product in the euro area and Japan by 0.2 and 0.4 percentage points, respectively.

In addition, emerging markets, which have seen a flood of capital inflows as a result of ultra-loose monetary policy in developed economies, would take a hit if investors turn risk averse and pull funds out, OECD said.

Outlook for JGB Market

The uncertain outlook for the Japanese government bond (JGB) market, which has proved to be exceptionally volatile in the recent weeks, poses a risk to the country's financial stability, OECD said.

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"On the one hand, stepped-up quantitative easing should have the impact of driving them [yields] down. On the other hand, higher inflation expectations as a result of the changed monetary regime could lead to an increase. Which of these effects prevails could have a strong influence on debt dynamics and fiscal sustainability," OECD said.

The spike in JGB yields last week triggered concerns over how the government would deal with an increase in debt financing costs.

The key risk for Japan is that its fiscal position becomes unsustainable, provoking a "crisis of confidence" in financial markets, OECD said.

"Delays in fiscal consolidation and the failure to establish a credible medium-term consolidation plan would risk provoking a change in investor sentiment and a run-up in borrowing costs."

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Fed Should Taper QE Soon

According to OECD, while U.S. monetary policy needs to remain "exceptionally accommodative for some time to come," a gradual reduction in the size of additional asset purchases may be warranted in the near future.

"Such a policy change would need to be carefully prepared and accompanied with clear communication of the reasons behind it and indications of how future adjustments will be decided and implemented," the organization said.

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The organization sees little need for additional stimulus, noting that the net benefits of this would be muted. It projects growth in the world's largest economy will remain moderate in 2013, and then "pick up noticeably" in 2014 as the labor market recovery gains momentum and headwinds from recent fiscal tightening fade.