FYI | Aug 16 2013
By Kathleen Brooks, Research Director UK EMEA FOREX.com
When bond markets start to move sit up and take notice. Even if you don’t trade fixed income per se, the movement of government bond yields, especially in the major developed markets like the US, UK, Europe and Japan can have a major impact across asset classes.
Multi-year highs for UK/ US yields
Now is the time to sit up: earlier today the 10 –year Treasury yield rose to its highest level since early August 2011, and the 10-year Gilt yield rose to a 2-year high earlier. The prospect of tapering in the US this September and a better run of economic data in the UK, causing the market to challenge the BOE’s pledge to keep interest rates low for the next 3 years, are the key drivers of these movements.
The markets are unwilling to take the world’s major central banks at their word: even though the Fed has been at pains to say that tapering is not easing and that it will only start tapering if the economic data stays supportive, the market has still pushed Treasury yields up neatly 120 basis points since May. In the UK, Gilt yields are more than 20 basis points higher than they were before last week’s Inflation Report. This is a huge move in a little over a week. In the same vein, short term yields are also moving higher as markets price in the prospect of future rate hikes.
Do rising rates matter?
Although no one expects rates to rise in the next 6-12 months, markets react to shifting perceptions. Whereas for the last 5 years we have lived in the happy complacency that interest rates were at record lows, now we have to get used to the cost of borrowing rising. Since there still remains excess debt in the world: including the developed economies and the Eurozone, in particular, and global growth is fragile, the prospect of rising borrowing costs, albeit from a low level, is the biggest event risk for financial markets for years. The cost of money is central for stocks and FX; interest rates are one of the key drivers of currencies, while rising interest rates are traditionally negative for stocks.
The question to ask now is: will rates continue to rise? Our view is: yes, if the economic data continues to strengthen and as long as central bankers don’t intervene to halt the increase in yields. In recent weeks the economic data has been mixed in the US, so unless we get some consistency in economic data and a strengthening in job growth, then it is hard to see Treasury yields continuing to rise. We think that central bank intervention is more of a risk in the UK. Yields are rising in direct defiance of the BOE’s new policy of forward guidance. Although the BOE has adopted a version of Forward-Guidance lite, we still think there are a number of doves at the MPC who will be alarmed by the pace of gains in bond yields, and may be tempted to step out and criticise this move by the market. There is a risk of this when Carney delivers his first public speech as BOE Governor on 28th August. Until then: strong economic data = rising Gilt yields = the potential for further GBP gains.
The great divergence: rising rates and the dollar
Interestingly, the dollar/ Treasury yield relationship has broken down since mid-July, Treasury yields have been pushing higher but the dollar has come under downward pressure. Usually there is a close positive relationship between these two, and in the past when there has been divergences the dollar has eventually played catch up. Thus, the decline to below 81.00 in the dollar index last week could be a medium-term low. We think the dollar could perform best against emerging market currencies (who react badly to rising US rates), the Aussie and Kiwi (who are exposed to the emerging world in Asia through their trade links) and the EUR (especially if this recovery in growth and employment turns out to be no more than a summer fling).
We are watching very closely to see how the Fed and the Bank of England would react if Treasuries and Gilt yields continue to extend gains towards 3%. Will this be the line in the sand where central banks say no more? Or could we be in a situation where rising interest rates are the prevailing trend and in 12 months’ time they are sitting at 5%? If yes, then we could be on the cusp of a very interesting development for all asset classes.
Figure 1:
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