Why Higher US Bond Yields Are No Reason To Panic
The yield on the US 10-year treasury notes – which in turn ‘’guides’’ the cost of money across the global financial system breached the psychological levels of 5 per cent before cooling off a tad lately. In fact, yields leapt more than 4 percentage points over the past three years. The last time yields moved as much in such a timespan was back in 1979 to 1982- when Fed Chairman Paul Volcker was fighting off the 1970s inflation, a period that saw not one but two recessions.
With the Israel-Hamas war threatening to go ‘regional’ we are now staring at the prospect of ‘’higher for longer oil’’. An oil price shock will reinvigorate risks of higher inflation. Moreover, this is coming on the back of the most aggressive rate hiking cycle from the U.S. Federal Reserve which incidentally continues to signal ‘higher for longer’ interest rates.
Why should US yields be such a big deal?
Given the strong linkages of the US economy with the rest of the world as a key provider of dollar liquidity, the rising yields impact other economies by dulling the lure of local interest rates and narrowing the interest rate differential between the US and the local economy.
Higher bond yields indicate a rise in the cost of funds in the financial system and bodes ill for banks holding large quantities of Treasury securities. It also translates to higher interest rates that people pay on credit cards, car loans and home mortgages and impacts businesses by raising their cost of debt which esp worrisome for companies whose investment-grade bonds or liabilities mature in the near term.
Should Indian consumers, companies and policymakers lose sleep over rising US yields?
Logically, if the US risk-free paper, widely considered to be one of the least risky investments in the world, is offering close to 5 per cent yield, should foreign investors even look at any other riskier investment class? The asking rate for equities goes up significantly if one were to adjust for risk premiums and currency hedging. With such high US bond yields, investors guided by the perception that these bonds are less risky than equities and yet offer more attractive return potential, tend to pull out funds from emerging markets like India and reallocate to US assets.
In the short run, investors or allocators of capital may not be very discerning. However, in the long run, fundamental macro factors such as growth prospects, underlying inflation and fiscal conditions matter more. Let us look at each one of these:
First, while US growth remains strong in the near term, it is being driven by a huge fiscal impulse to keep the economy afloat which is aggravating the divergence between the fiscal and monetary policies. The government has been splurging and it runs a $2.02 trillion budget deficit for the fiscal year through September (USD 1.02 trillion more than last year) and looks like it will exceed 7 per cent of GDP in 2023. There is a risk of recession down the road for the US when this impulse fades and the lagged effect of high-interest rates kick in.
Second, truth be told, when was the last time one saw inflation staying 2-4x of the Fed’s inflation target of 2 per cent for a sustained period of time? Higher US yields thus, are also a reflection of the inflation problem that has remained sticky and rather untamed in spite of over 500 bps rate hike.
Third, this surge has led the U.S. government to issue ever more debt through an avalanche of Treasury issuances causing a mismatch between demand and supply of treasuries that pulls yields even higher.
Most importantly, there has been a steady deterioration in standards of governance over the last 20 years, including on fiscal and debt matters. the June bipartisan agreement to suspend the debt limit until Jan’25. The constant political bickering over the debt limit, government shutdowns and divergent fiscal and monetary policy stance will continue to cause anxiety globally.
In contrast, despite the adverse global backdrop, India has managed to maintain macro stability with the government adhering to fiscal consolidation and the RBI taking proactive steps to tame inflation. This conducive fiscal-monetary tango ensures growth certainty and stability in India something that investors and markets love. It also gives the RBI the freedom to pursue policy choices based on India’s underlying economic undercurrents and not remain beholden to the US Fed.
(The writer is Group Chief Economist, L&T. Views expressed in the article are the writer's own thoughts and not of L&Ts)
