US Fed rate hike in sight
It's now a virtual certainty that the US Federal Reserve is on course to raise rates for the first time in nine years. September seems the most likely timing for the hike; which is about a month away. Yet there seems to be little movement in the interest rate markets to suggest that this long awaited move towards normalization of monetary policy in the US is around the corner.
On a year-to-date basis, the yield on the benchmark 10-year US treasury bond is up just 9 basis points (bps). (One basis point is onehundredth of a percentage point.) The reaction across the shorter end of the yield curve has not been very different, with the yield on the twoyear treasury bond up 6 bps, while the five-year bond yield has actually fallen by about 2 bps. Notably, an increase in yields earlier in the year has almost entirely been reversed. Starting midApril, global bond yields had started to rise and many of us had wondered whether the long feared global bond sell-off was beginning. Between 17 April and 10 June, the US 10-year yield rose by about 60 bps-an increase that had followed a surge in bond yields in European markets such as Germany.
In hindsight, that spike in yields proved to be temporary. The US 10-year yield, for instance, has fallen 22 bps and is currently at about a two-month low. The question is-why are the bond markets so quiet if an increase in interest rates is around the corner? Here are some of theories doing the rounds. One reason for this is the expected trajectory of interest rates in the US. While markets are resigned to the fact that the first rate hike will happen this year, the view is that the pace of increase in interest rates from here on will be slow. The Fed has said as much. "The Committee (Federal Open Market Committee) currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run," said the Fed in its July statement.
Analysts, too, believe that economic conditions (both global and domestic) will not allow the Fed to raise rates too quickly and that's one reason why bond yields are not running up despite the prospect of interest rate increases in the world's largest economy.
The resumption of the global commodity slump is another reason why bond yields have been subdued. After a period of steadiness, commodity prices have started to fall again. Crude oil prices in the US are back at fivemonth lows, having slipped 20% since the beginning of July. Along with crude, metal prices are falling, as are prices of agricultural commodities such as sugar and soy bean. The emerging view is that the commodity correction may not be short lived. Majority views suggest that events such as the Iran nuclear deal and the slump in China may keep commodity prices low for some time to come. All taken together, this softness in commodity prices could prevent inflation rates from hitting the Fed's target levels of 2%, which, in turn, will prevent quick rate hikes.
A third factor that is keeping US bond prices high and bond yields low is, very simply, demand. The global environment remains volatile with most developed and developing economies (with a few exceptions) struggling. While the Greek crisis has blown over for now, the European economy remains weak. China, where the stock market slump continues, is increasingly making global investors nervous. While it was earlier thought that China's troubles would be localized, the reaction in the commodity markets has proved otherwise. In turn, the commodity price plunge has left a number of commodity exporting emerging economies in a mess. Brazil and Russia are examples of this. What this has done is keep the demand for safe haven assets high and most of this demand is being routed to dollarassets, in particular US treasuries.
All taken together, what this means is that-contrary to the long-held belief-bond yields may actually not surge in response to an increase in US interest rates. If it actually plays out this way, it won't be the first time that the interest rate markets would have defied expectation and explanation.