Commentary on Political Economy

Monday 8 March 2021



Financial castles built on sand

Karen Maley

Investors have long used the US 10-year bond yield as the benchmark for pricing all financial assets, including shares and property. But what happens when they suspect it’s a “fake” rate?

What will happen to financial markets if investors start to lose confidence in the foundation stone that underpins the whole financial system: the US 10-year bond rate?

Investors have become increasingly alarmed the yield on benchmark US 10-year bonds has risen to 1.6 per cent, up from 0.92 per cent at the end of last year.

A significant rise in US 10-year bond yields has the potential to trigger a repricing of all financial assets. Michele Mossop

That means that bond yields are now back to levels in early 2020, before the pandemic struck.

It’s hardly surprising that the 10-year US bond yield has moved sharply higher.

The US economy is rebounding strongly from the pandemic, with the unemployment rate falling to 6.2 per cent in February.

And the recovery will be given a further boost as a result of US President Joe Biden’s $US1.9 trillion ($2.5 trillion) economic stimulus plan, which has now passed the US Senate.

The problem is that the US 10-year bond is viewed as the global risk-free asset. And that means that its yield is considered the benchmark when it comes to setting the price of all other financial assets.

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That’s why investors are keeping such a nervous watch on the US bond market at present.

A significant rise in US 10-year bond yields (yields rise when bond prices fall) has the potential to trigger a repricing of all financial assets.

That’s because it only makes sense for the US equity market to be trading close to record highs because bond yields are so low.

And it only makes sense for investors to accept ultra-low property yields because bond yields are so low.

Indeed, because the whole global financial edifice is built on extremely low US bond yields, there’s growing pressure on the US Federal Reserve to promise to keep a lid on long-term bond yields.

Markets were keenly disappointed last week when the Fed boss Jerome Powell failed to promise the US central bank would intervene to tamp down rising long-term bond yields.

Ultra-easy monetary policies

Instead, the US central bank boss merely repeated the US central bank intended to keep its official cash rate close to zero, and would continue to buy $US120 billion of US government bonds and mortgage-backed securities each month.

These ultra-easy monetary policies, he promised, would remain in place until the US reached maximum employment, and inflation consistently exceeded 2 per cent.

Still, some analysts believe the Fed will be forced to intervene if US bond yields rise too far.

They point out that the Fed could follow the lead of the Reserve Bank of Australia in embracing yield curve control. The Australian central bank has set a target of 0.1 per cent for three-year government bonds, pledging to buy as many government bonds as necessary to achieve this target.

What’s more, the Fed has itself previously pegged bond yields. During World War II, it capped the rate on long-term US government bonds at 2.5 per cent in order to make it easier to finance the war effort.

Some suspect that the ballooning US budget deficit will eventually force the Fed to set a cap on long-term US bond yields, otherwise the US government’s borrowing costs will jump sharply.

Investors worry real, inflation-adjusted, bond yields are still extremely low, given the fiscal and monetary stimulus introduced worldwide in the past year.

Even if the Fed doesn’t announce an official target for the US 10-year bond yield, the big global banks have clearly demonstrated that they have more than enough fire-power to push bond yields to whatever level they choose.

The major global central banks simply need to ramp up their already massive bond-buying programs, in order to suppress bond yields.

The problem is that although the world’s major central banks can easily usurp the market’s role in setting the benchmark for the 10-year bond yield, there’s a danger that this policy could backfire.

Because bond markets serve a critical function in setting the benchmark yield, against which other financial assets are valued.

And so while it’s true that central banks can achieve whatever bond rate they want, at some point there is the risk that bond yields lose their credibility as a benchmark if central banks intervene too aggressively.

Apprehension in markets

Already, there are increasing signs that investors are beginning to doubt whether long-term bond yields are a true reflection of the likely course of short-term interest rates over the next decade.

Investors are worried that real, inflation-adjusted, bond yields are still extremely low, given the extraordinary fiscal and monetary stimulus that has been introduced worldwide in the past year.

And there’s clearly considerable apprehension in financial markets that bond yields will inevitably push higher in coming years.

Investors simply don’t believe that strong global economic recovery is compatible with the sanguine belief in continuing low inflation.

But, more worryingly, investors are no longer relying on the US 10-year bond yield to provide an accurate gauge of future inflation risks.

And this is increasingly causing them to question whether it should be employed as the yardstick for setting the prices of other financial assets.

One indication of this is that investors are now demanding a higher equity risk premium – the additional compensation that investors demand for investing in stocks rather than low-risk bonds.

Even though the US equity market is close to record highs, the equity risk premium is higher than it was several years ago.

Now, this rise in the equity risk premium possibly reflects nervousness that corporate earnings could disappoint even as the US economy recovers and the jobless rate falls.

But a more likely explanation is that investors are increasingly of the view that central bank’s bond buying programs have manipulated the US 10-year bond yield to such an extent that it is no longer a valid benchmark.

Wall Street traders are likely to have drawn encouragement from an upbeat jobs report.

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As a result, they’re less confident that the US 10-year bond yield still serves as a stable foundation stone for the global financial system.

As Michael Wilson, the chief US equity strategist at Morgan Stanley, wrote in his latest investor note, “the equity market now knows the 10-year yield is a ‘fake’ rate that either can’t or won’t be defended.”

He points out that even though the Fed expanded its balance sheet by $US180 billion in February – which is 50 per cent more than its target purchases – bond yields still pushed higher.

What’s more, Wilson predicts the equity risk premium could now push higher as investors anticipate the next 0.5 percentage point rise in US bond yields.

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