Overnight, the Bank of Japan will choose whether to take the first step in unraveling a policy that has kept Japan's interest rates near zero for five years.

Global bond markets have sold off in anticipation of the move for several weeks, putting pressure on stock and commodity markets the world over. The trend continued in commodities Wednesday, most notably gold and silver, while U.S. stock averages overcame early weakness and the Treasury market ended mixed.

Recent nervousness that has hit financial markets stems from the realization that, should the BOJ make a move, all of the world's key central banks will now be in tightening mode. That would reduce the liquidity that has become the trademark of global financial markets in recent years.

The European Central Bank lifted its key rate to 2.5% last week and ECB officials have been signaling more rate hikes are on the way as eurozone economies, and inflationary pressures, are showing signs of life.

As for the Federal Reserve, the market fully expects it to deliver another rate hike on March 28, which would take the fed funds rate to 4.75%. The market is also pricing in 90% odds that the rate will reach 5% in May and has started to price in odds, currently at 8%, of another hike to 5.25% by the end of June.

Speaking on Tuesday, Chicago Fed President William Poole confirmed that rates would have to rise further.

Stocks still recovered from earlier weakness, helped in part by a further drop in crude oil prices. The Dow Jones Industrial Average recovered from a 55-point drop to close up 25 points, or 0.2%, to 11,005. The S&P 500 also rose 0.2% to 1278.

The Street celebrated the first day of trading of the NYSE Group ( NYX), which soared 25%.

The Nasdaq Composite continued its weaker trend, falling 0.01% to 2268 but off its intraday low of 2,248.65. Google ( GOOG) dropped 3% after the Internet search engine revealed it made another gaffe by accidentally releasing financial forecasts on the Web in conjunction with its analyst day meeting last week.

The 10-year Treasury bond, meanwhile, fell slightly ahead of the BOJ decision, losing 2/32 while its yield, which moves inversely, rose to 4.73%. The bond has been selling off over the past few weeks and its current yield is a good 20 basis points above where it stood for most of February. The recent selling of long-dated Treasuries did reverse the inversion between 10- and two-year yields that had been in effect since January.

Global bond markets have also been weak recently. The 10-year German bund yield has risen more than 17 basis points while a Japanese government bond (JGB) of the same maturity has gained more than 12 basis points since late February, according to Morgan Stanley.

On Wednesday, the bund's price fell and its yield rose to 3.64%. The JGB, however, rose and its yield fell to 1.61%. The move came on the heels of more flip-flopping on the part of Japanese officials and politicians over whether to endorse the end of the BOJ's "quantitative easing" policy, which has pumped trillions of yen into the banking system.

Hidenao Nakagawa, head of the ruling Liberal Democratic Party, said that Japan has yet to beat deflation, according to Bloomberg. He declined to say whether it was desirable for the BOJ to delay any move until April.

The comments pressured the yen, which fell against both the dollar and the euro. But economic data overnight showing that bank lending increased for the first time in nine years, by 0.2% in February, supported the case that deflation is over in Japan.

According to Ashraf Laidi, currency strategist at MG Financial, the BOJ will make a small move to restrain liquidity overnight. But it will be very cautious in making any predictions about ending the zero-rate policy. Most observers don't expect the bank to nudge rates until next year.

By historical standards, short- and long-term rates across the world, including in the U.S., remain abnormally low. These rates have helped the global economy grow above trend -- it was up 4.5% last year -- and now the world's central banks are slowly turning "the liquidity spigot," notes Stephen Roach, chief economist at Morgan Stanley.

The extraordinarily low rates of the past few years have not only encouraged borrowing at unprecedented levels -- i.e. the U.S. housing bubble -- but also fueled risky investments into everything from stocks, commodities and emerging markets, says Roach. The economist has been warning of a nasty reversal of these trends should long rates start rising earnestly. He's now seeing the beginning of his predictions come true.

"The message from the recent selloff in global bond markets should not be ignored," Roach wrote. If the era of low long-term interest rates does end, "that could have profound implications for the interest rate-dependent global economy."

First and foremost on everybody's mind is the U.S. housing market, which has shown undeniable signs of cooling since last summer. On Wednesday, the Mortgage Bankers Association said its applications index rose 0.7% last week but that its purchasing applications dropped 0.4%.

Through mortgage equity withdrawal and refinancing, U.S. consumers have used their homes as ATMs to extract and spend more than $600 billion last year, according to former Fed Chairman Alan Greenspan. As the housing market slows, U.S. consumption and the global economy are also bound to slow, Roach warns.

Of course, the financial markets may be overreacting in early anticipation of such trends, which have included recent strength in defensive stocks such as Kellogg ( K) and Procter & Gamble ( PG). "There is a lot of rate uncertainty out there," says John Lonski, chief economist at Moody's.

But the immediate consideration facing global investors is not the imminent end of global economic and earnings growth. "The bigger worry is that stocks are facing stiffer competition from money market funds, whether they be short-term bonds or CDs," Lonski says.

Indeed, a six-month CD is now returning 5%, according to The Wall Street Journal. That's better than the 4.9% return of the S&P 500 for all of last year, including dividends.

For Lonski, the surprise is that it's taken so long for long bond rates to react to rising short-term rates. He believes the yield of the 10-year Treasury bond might rise to 5.25% in the second half of 2005. "Anything above that could become worrisome for the global economy," he says.

That's still a long way away. But given the recent trends, it seems global markets are beginning to price in some of those risks early. The reaction to the BOJ's move, or lack thereof, might tell the story.
In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback; click here to send him an email.

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