By John Geddie
LONDON (Reuters) - Global bond yields will rise modestly and spikes in volatility could be more commonplace in the coming years as loose central bank policy loses its potency, Pimco's bonds CIO said on Friday.
Andrew Balls, the fund's chief investment officer for global fixed income, also said financial markets were underestimating how quickly the U.S. Federal Reserve would raise interest rates, and that the Bank of England would not have to cut rates again this year to tackle the economic fallout from Brexit.
In a bid to revive growth and inflation, which have struggled to recover since the 2008 financial crisis, central banks have slashed interest rates -- below zero in many cases -- and printed trillions of dollars for bond-buying splurges.
But a shift in the Bank of Japan's approach this week is a signal to some that monetary policy might be reaching its limits, fuelling speculation that a 35-year-long rally in bond markets, which has crushed yields, may be over.
"Central banks running out of rope over time is going to lead to higher risk premium, and we think you are going to see a gradual rise in the coming years in bond yields and equity risk premiums," Balls said.
While Europe and Japan have pledged to keep monetary conditions easy, the Fed is toying with raising rates for just the second time this decade as the world's largest economy, the United States, recovers.
Balls said that, while rates would not return to anywhere near levels seen at the turn of the century, hikes in the coming years could come faster than investors expect.
The investment manager, formally Pacific Investment Management Co, expects the Fed to hike in December and twice in 2017. Money market rates indicate around a 50 percent chance of a December hike, and just a 25 percent chance of a further rise next year, according to CME Group's FedWatch.
SPIKES AND TANTRUMS
Balls said the tightening of monetary conditions could give rise to sudden market jolts, similar to those seen when the Fed started to row back its quantitative easing scheme in 2013.
"There is the possibility we are going to get more mini 'taper tantrums' and spikes in volatility," he said.
"So far, central banks have been able to pretty quickly suppress this, and you saw that after Brexit, but the declining effectiveness of central banks is an issue."
Emerging economies, many of which borrow large amounts in dollars, could also have problems refinancing their debt if higher U.S. rates lead to a stronger currency.
But Balls said the risk was manageable and noted signs of economic improvement in many countries.
"We were very underweight emerging markets over last few years, now we are probably neutral. But we still think valuations look reasonable and we will probably allocate more of our risk budget to emerging markets."
Turning to Britain, Balls said he did not expect the Bank of England to cut interest rates for a second time this year, with the fallout of June's vote to leave the European Union looking fairly contained for now.
"Our baseline (scenario) is that we have a cyclical slowdown and it becomes clear that the offer is a reasonable one and not too destabilising in terms of the macro economy," said Balls, the brother of Ed Balls, former finance spokesman for the opposition Labour Party.
"We think the Bank of England are probably quite pleased as they acted pre-emptively. We don't think they will do anything more this year."
Balls said Pimco had sold some of its holdings of British government bonds and reduced its short position on the pound.
Pimco, a unit of the German insurer Allianz SE, is headquartered in Newport Beach, California, with more than $1.5 trillion in assets under management.
(Editing by Kevin Liffey)