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Global long-term rates holding onto postelection surge

Many long-term rates around the world continue to move higher, building on the sharp increases witnessed in the aftermath of the U.S. presidential election.

The yields on 10-year sovereign bonds rose in 12 of the 15 largest global economies in January. Only Brazil, India and Russia saw the yields on their 10-year bonds decline between year-end 2016 and Jan. 27.

During the same period, long-term rates rose in three of the four largest economies in the Americas and posted even larger increases in Europe. With the exception of Russia, the yields on 10-year bonds in Europe rose by at least 20 basis points in January.

The increases in long-term rates in recent weeks, in most cases, added to the surge in global bond yields sustained after Donald Trump's surprise victory in the U.S. presidential election. In the month following the election, the yields on 10-year sovereign bonds rose in 14 of the 15 largest economies in the world.

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Long-term rates climbed as some market observers believed Trump's policies would increase the deficit by boosting infrastructure spending while cutting taxes. Long-term rates also went higher as some other observers expected stronger economic growth to come from proposed fiscal stimulus and talks of a more business-friendly environment in the U.S.

The Federal Reserve offered some support for that thinking as well, with its Federal Open Market Committee opting in December 2016 to raise the federal funds rate for the first time in almost a year. Not long after that, several members of the FOMC said they believed a stronger economy and the prospect of higher fiscal spending would prompt a more aggressive rate hike stance in 2017. Still, the Fed decided to hold the fed funds rate unchanged during its first meeting in 2017 and failed to offer much insight into future policy actions.

Financial institutions have waited some time for interest rates to move higher. While increases in long-term rates likely will serve as a headwind to mortgage banking income due to slower mortgage refinancing activity, higher rates offer a wide array of financial institutions opportunities to reinvest cash flows at more attractive yields in the bond market. Banks also likely will see higher yields on newly originated loans and should see yields on variable-rate loans move higher.

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A number of those loans are tied to benchmark rates like U.S. dollar LIBOR, which has jumped over the last six months. Three-month, U.S. Dollar LIBOR began rising in the summer of 2016 ahead of planned money market reform in mid-October. That regulation required prime institutional money market funds' net asset values to float, and for both prime institutional and retail funds to impose gates and liquidity fees during periods of extreme volatility.

The rule change has spurred significant outflows in prime money market funds. Since July 2016, data provided by the Investment Company Institute shows that more than $600 billion has left prime funds, while nearly $630 billion has moved into government money market funds, pushing LIBOR higher. During that period, three-month U.S. dollar LIBOR has risen close to 35 basis points, or beyond the rate hike by the Federal Reserve in December.

The increase in LIBOR helped drive loan yields higher for a number of banks in the fourth quarter of 2016 even though the fed funds rate remained unchanged for much of the period. The continued increase in LIBOR prompted some banks to offer a more positive outlook for net interest income in the coming year, even if the Federal Reserve does not take further actions. For instance, banks like Bank of America Corp. and Hancock Holding Co. see important metrics like interest income and net interest margins rising, even without further rate increases by the Fed.

Just how high rates will go remains unclear. The futures market projects a 56% probability that the Fed will raise rates two or three times in 2017, lifting the fed funds target range to as high as 125 to 150 basis points by December 2017. Meanwhile, long-term rates in a few of the world largest economies, including the U.S., have declined from the recent highs sustained in mid-December. The modest rally in several key long-term rates suggests that global investors still have some money sitting on the sidelines, waiting to take advantage of higher yields should they come to pass.

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