Bond yields remain a benchmark for banks to set interest rates for lending purposes. An elevated bond yield will trigger interest hikes from banks without the need for Central Banks of respective countries to increase policy rates
The US treasury bond yields jumped over 5 per cent last week for the first time in a decade-and-a-half and could engineer yet another rate pause this time, when the US Federal Reserve’s Open Market Committee Meeting (FOMC) begins on October 30. The reason is simple as bond yields remain a benchmark for banks to set interest rates for lending purposes. An elevated bond yield will trigger interest hikes from banks without the need for central banks of respective countries to increase policy rates and in this case the US Fed.
As US remains a dominating country in the world it also anchors geo-political strategic manoeuvrings and backs its allies by putting around its weight. After the Russia-Ukraine war which is still ongoing and the West is backing the war-torn Ukraine, a new war has erupted between Israel and Hamas.
But what is now deepening the crisis is the Arab countries standing up for Palestine increasingly casualties keep going up in the full-blown offensive against the Hamas. What was earlier being perceived as a limited period offensive against the Hamas is now ballooning into potential war which could last longer than anticipated.
Not delving too much into the crisis, we will talk about how it impacts the Fed policy and the interest rate regime in the world’s largest economy.
The 10-year US treasury bonds are the most widely traded paper across global financial markets because of their steady yields. Not just backed by sovereign guarantee, their stability makes them the most secure financial instruments thus making them most sought after.
Through government bonds, governments meet its long, medium and short-term financial obligations. Governments raise money by issuing these bonds and in return, offer interest payments to the lenders.
They are also a great hedge for investors and are kept as reserve currency at the time of crisis.
In the recent months, the US Treasury (government) has issued a lot of government debt to fund wars in Ukraine and the now in the Middle East. The US government could continue doing so if the war escalates further. This may take the bond yields (or coupon rates at which bonds are issued), further up making them expensive for government to raise loans from the market. Since the banks benchmark their lending rates against the treasury yields, they could follow suit and up lending rates making home loans, vehicle loan and personal loans dearer.
As yields go up, the bond prices will come down by virtue of an inverse relationship between bond yields and bond prices. And as bond prices come down more investors will rush to buy these bonds at lower rates and higher interest rates. This could create a double whammy — one that the bond yields could continue to move north and second that the investors will start diverting money to government bonds from other asset classes.
When the bond yields jumped above the 5 per cent mark, it was the first time since 2007. They had tested this level just before the global financial crisis.
A media report suggested that the 30-year fixed rate mortgage in the US has moved to as high as 8 per cent which has not happened since the dot-com bubble burst in 2000.
The Fed’s Feelers
Several Fed policymakers have hinted for a rate pause in the upcoming monetary policy maintaining the rates at 5.25-5.50 per cent. In the last September policy, Fed left interest rates changed while emphasising that the higher for longer regime will continue for longer that was previously anticipated. The FOMC meeting outcome also outlined that the rate cut will be half a percentage point and not 1 per cent as was previously expected.
The 2 per cent target inflation remains sacrosanct for the US Central Bank and it will do what it takes to reach there.
It was also expected that the Fed could go up for one more rate hike of 25 bps this year before it adopts a long pause. But now as the yields are rising, Fed may be forced to push a pause button.
An agency report is pointing out that the American housing market has frozen as sales hit a 13-year low. Home sales dropped across the US in September. As the home sales inventory remains low, prices of new houses shot up and rates that crossed over 7 per cent in August have pulled down sales to their lowest level in 13 years, according to a monthly report from the National Association of Realtors, this report said.
Prices have reached a point where buying a house has become unaffordable for many.
The Israel-Hamas conflict has once again sparked fears of inflation striking back. The Fed is also warning against the perils of war escalation. If the war grows from here, we could see global economic activity going down and inflation propping up.
Despite all the speed breakers in the form of Covid 19, Russia-Ukraine war, banking crisis, US has been able to weather-out the storm. But the uncertainties are coming far too quickly. The challenge is not just for the US but all major economies.
As most economies follow the US, it will be interesting to see how the world converges on this issue to tackle the crisis, this time around.