Market players have been paying attention to U.S. government bond yields lately. What’s up with that? Well, hopefully today’s write-up will help you make sense of what’s happening.
By the way, if you’re a newbie who somehow stumbled across this article, and you have absolutely no idea what bonds and bond yields are, then you may wanna check out our School’s lesson on How Bond Yields Affect Currency Movements.
But assuming you already have the basics…
Why do investors keep tabs on bond yields?
Investors pay attention to bond yields because (under normal circumstances) rising bond yields are a sign of a strong economy since bond yields usually rise because investors are selling bonds and loading up on riskier assets such as stocks.
And if the economy is in bad shape, then investors won’t be too eager to load up on risky assets and prefer to load up on safe assets instead. And since government bonds are super safe (given that they’re guaranteed by the government), investors usually buy up bonds during risk-off times, causing bond yields to fall.
Another reason why investors pay attention to bond yields is because bond yields are also linked to inflation expectations and interest rates.
This one is a bit complex to explain, but I’ll try my best.
First, you should understand the difference between primary and secondary markets.
Let’s first talk about stocks. When companies issue new shares, they don’t sell them directly to the stock exchange. Instead, companies issue new shares in the primary capital market, usually an initial public offering (IPO).
And if the investors who bought those shares during an IPO decided to sell their shares they sell it in the secondary market (i.e. the stock exchange).
In the case of bonds, governments usually hold bond auctions (the primary market) and investors who bought bonds at these bond auctions can then sell their bonds to the secondary market. There is no centralized exchange for bonds, so bonds are usually traded “over the counter” with banks usually acting as broker-dealers.
Still with me? Good!
As the name suggests, bond auctions mean that bonds are sold to the highest bidder, especially if there are a lot of buyers.
However, buying bonds above the maturity value of the bond will naturally lower the yield of the bond.
And if inflation continues to rise, then buyers who bought at the primary market may decide that the yield of their bond holdings may not be able to keep up with rising inflation, so they sell their bonds in the secondary market, which lowers the price of bonds while causing bond yields to rise.
And that’s why bond yields are also used to gauge inflation expectations. And as a logical consequence of higher inflation expectations, odds that there will be more rate hikes down the road also increase.
See? That wasn’t too hard, right?
Do bond yields affect the economy?
Yes. Next question! Okay, okay. I’ll explain a bit.
When I’m talking about bonds, I’m referring only to government bonds. However, governments aren’t the only ones who sell bonds since corporations sell bonds as well.
However, government bonds are seen as super safe (since governments rarely become bankrupt), while corporate bonds are viewed as less safe.
To compensate for being less safe, corporate bonds usually have higher yields. Otherwise, investors will only buy government bonds all the time.
However, if government bond yields rise, then corporations must also increase the interest rates they pay on bonds in order not to lose investors. And that eats up the profit margin of corporations.
Basically, higher government bond yields signal tighter credit conditions for companies. And tighter credit conditions mean potentially slower growth.
And in the case of the U.S., higher government bond yields also mean that banks can (and usually will) charge higher mortgage rates, which dampens the housing market and consumption. But if the economy is healthy and wages are growing, then that’s not really too bad.
As a side note (not really), if corporations increase the interest rates on their bonds, then the government would also usually increase the interest rates on government bonds during the next auction in order to attract investors.
This causes bond yields to rise steadily which attracts investors, including foreign investors, thereby strengthening that country’s currency as well.
Why are investors worried about bonds?
If you read everything I wrote above, then you may have realized that rising bond yields are not really that bad.
And that’s correct. Rising bond yields are not really a source of concern, provided the rise is not too rapid. But even if the rise is rapid, investors usually don’t mind if the economy is in good shape or is expected to grow faster.
Bond yields surged when Trump won the presidential race back in November 2016, for example, but equities also rallied since the market was more focused on Trump’s fiscal plans back then.
However, the recent rise in U.S. bond yields was rapid and breached multi-year highs to boot, which stoked fears that bond yields will rise even further.
The yield of benchmark 10-year U.S. government bonds, for example, recently reached the 7-1/2-year high of 3.25% before backing off. And that triggered fears of tighter credit conditions and slower U.S. economic growth.
And while the U.S. economy is doing pretty good, there is that ongoing trade war with China, which presents a downside risk for economic growth, so investors are none too happy with the recent surge in U.S. bond yields.
Also, some market analysts are saying that yields in excess of 3% would make U.S. bonds more favorable at the expense of equities, although other market analysts are saying that U.S. bond yields need to rise to 4% or even 5% before bonds become more attractive compared to equities, so equities can still recover.
How did the recent bond surge affect other currencies?
If you’ve been reading up on Pip Diddy’s weekly recaps, then you already know that the surge in U.S. bond yields was good for the Greenback.
But what about the other currencies? Were they affected by the recent bond surge?
Well, the Aussie and the Kiwi are worth highlighting since they are no longer higher-yielding currencies relative to the Greenback, which is why they have been vulnerable to the Greenback’s strength lately.
And all the more so, given that the RBNZ has a neutral monetary policy bias, while the RBA has a hiking bias but is not in a hurry to hike rates. And this monetary policy divergence is only amplified by the wider yield gaps.
The yen is also worth noting since there’s a huge gap between the yield of benchmark 10-year U.S. government bonds and the yield of 10-year Japanese government bonds (JGB) since the BOJ wants to keep the yield of 10-year JGBs at around 0%. And the BOJ does that via its QE program.
However, the yield of 10-year JGBs have been moving higher and away from 0% lately, but the BOJ doesn’t seem too concerned, which is probably why the yen is now the safe-haven of choice for most investors (even at the Greenback’s expense).