Bond yield and related topics

Bond yield and related topics

Subject :Economy

Section: External Sector 

Context:

Notwithstanding rapid increases in interest rates by the US central bank, the inflation rate for June came in at 9.1%.

Many observers have pointed this to an inversion of the US yield curve and argue that the US central bank will not be able to achieve a soft-landing for the economy.

Further, there has been a tendency of  “reverse currency war” as  most central banks across the world are trying to raise their interest rates to counter the Fed’s actions and ensure their respective currency stops depreciating against the dollar.

Concept:

Bond yield curve inversion:

• The yield curve is the graphical representation of yields from bonds (with an equal credit rating) over different time horizons.
• Example– if one was to take the US government bonds of different tenures and plot them according to the yields they provide, one would get the yield curve.

• Under normal circumstances, any economy would have an upward sloping yield curve.
  • Meaning-as one buys bonds of longer tenure — one gets higher yields.
  • If one is parting with money for a longer duration, the return should be higher. Moreover, a longer tenure also implies that there is a greater risk of failure. 
• Bond yield curve becomes inverted when bonds with a tenure of 2 years end up paying out higher yields than bonds with a 10 year tenure.
  • Such an inversion of the yield curve essentially suggests that investors expect future growth to be weak. 
  • When investors suspect that the economy is heading for trouble, they pull out money from short-term risky assets (such as stock markets) and put them in long-term bonds. This causes the prices of the long-term bonds to rise and their yields to fall (bond prices and bond yields are inversely related).
  • Inversion of the bond yield curve has become a strong predictor of recessions. 
  • In the current instance, the US Fed has been raising short-term interest rates, which further increase the short-end of the yield curve while dampening economic activity.

Soft-landing:

• The process of monetary tightening (raising rate of interest) reduces the money supply and increases the cost of money (that is, the interest rate).  It is mostly done to contain soaring inflation.
• Ideally, any central bank monetary tightening slows down the economy but doesn’t lead to a recession. 
  • Increasing the rate of interest reduces private investment and growth.
• When a central bank is successful in slowing down the economy without bringing about a recession, it is called a soft-landing — that is, no one gets hurt.
• But when the actions of the central bank bring about a recession, it is called a hard-landing.
• Example-Given the massive gap between the current US inflation rate — over 9%— and the Fed’s target inflation rate — 2% — most observers expect that the Fed would have to resort to such aggressive monetary tightening that the US economy will end up having a hard-landing.

Reverse currency war:

• Raising interest rates cause capital inflows due to interest rate differential causing appreciation of currency.
• Example– the recent Fed interest hike has led to large scale capital inflows in the US causing appreciation of the dollar to other currencies because the dollar is more in demand than yen, euro, yuan etc.
• This relative weakness of local currency against the dollar makes their exports more competitive.
  • For instance, a Chinese or an Indian exporter gets a massive boost. In fact, in the past the US has often accused other countries of keeping its currency weaker against the dollar  just to enjoy a trade surplus against the US. This used to be called the currency war.
• Today, every central bank is trying to figure out ways to counter the US Fed and raise their interest rates in order to ensure their currency doesn’t lose too much value against the dollar. This is called the reverse currency war.
  • A currency which is losing value to the dollar, finds that it is getting costlier to import crude oil and other commodities that are often traded in dollars.
  • But raising the interest rate is not without its own risks. Just like in the US, higher interest rates will decrease the chances of a soft-landing for any other economy.