Flattening yield curve in the US…why?
The current hot topic to discuss is the negative yield curve. Yesterday (27th December 2005) the 2 year bond’s yield of 4.347% was 0.4 bps ahead of 10 years’ 4.343%. As we all know that the previous 6 recessions were preceded by the inverted yield curve. That gives no incentive for the financial institutions to borrow short term loans and lend for longer terms to enjoy the spread.
Why the long term bond interest rate is abysmally low in the US…is it because of the gloomy US economic future or something else driving it? Long term yield should be more as it contains duration risk…higher duration leads to higher inherent rate and market risks. If we see from the angle of demand and supply we can unearth a reason. As with other economic products, interest rate is also determined by the demand and supply of the bonds which are further driven by factors like expectation, growth, political and financial uncertainty, etc.
Higher the demand for bonds, higher will be the bond price and thus lower bond yield (as interest rate/yield is inversely related to the bond price). The demand-supply study revels that the current interest rate is heading downwards because of the huge demands of US bonds by the global exporters like Japan and China and also by the European investors.
Thanks to the US consumption led economy, it is facing a record trade deficit (which is at a run rate of $750bn for 2005…more than the size of Indian economy!!!). The exporting countries like China and Japan are enjoying a huge trade surplus with the US. Now with zero or negative savings rate in the US, how the US will fund for these deficits? The exporters come into the picture and they finance the US’ import by supplying enough of Dollars by buying the US Dollar denominated bonds. Japanese had the incentive to invest in the US bonds as they give interest of around 4.5-4.7% as against their home rate of near zero. Thus USD is transferred to the US’s coffer. Also, this year Europeans have invested in the US bonds as to enjoy the spread and to avoid any uncertainty in the home markets due to a number of factors like:
• Uncertainty in the EU after France and the Netherlands did not agree to the EU legislation earlier during 2005. Some felt that it may lead to the gradual fall of the EU.
• Increasing German unemployment rate which now hovers in double digits
• Social unrest in France during November
• Terrorist threat post 7/26 in the UK.
The European did not mind putting in their money in foreign country when it is the US. So, the exporters led bonds’ demand coupled with the European factors increased the bond’s prices thus led to the fall in the interest rates of the long term bonds. And the 14% rise of USD against the Euro and JPY each can also be associated with this argument, as the European and Japanese would need USD to buy the US bonds. Hence, among others, increase USD demands against the Euro and Yen led to the rise in the USD this year.
Why the long term bond interest rate is abysmally low in the US…is it because of the gloomy US economic future or something else driving it? Long term yield should be more as it contains duration risk…higher duration leads to higher inherent rate and market risks. If we see from the angle of demand and supply we can unearth a reason. As with other economic products, interest rate is also determined by the demand and supply of the bonds which are further driven by factors like expectation, growth, political and financial uncertainty, etc.
Higher the demand for bonds, higher will be the bond price and thus lower bond yield (as interest rate/yield is inversely related to the bond price). The demand-supply study revels that the current interest rate is heading downwards because of the huge demands of US bonds by the global exporters like Japan and China and also by the European investors.
Thanks to the US consumption led economy, it is facing a record trade deficit (which is at a run rate of $750bn for 2005…more than the size of Indian economy!!!). The exporting countries like China and Japan are enjoying a huge trade surplus with the US. Now with zero or negative savings rate in the US, how the US will fund for these deficits? The exporters come into the picture and they finance the US’ import by supplying enough of Dollars by buying the US Dollar denominated bonds. Japanese had the incentive to invest in the US bonds as they give interest of around 4.5-4.7% as against their home rate of near zero. Thus USD is transferred to the US’s coffer. Also, this year Europeans have invested in the US bonds as to enjoy the spread and to avoid any uncertainty in the home markets due to a number of factors like:
• Uncertainty in the EU after France and the Netherlands did not agree to the EU legislation earlier during 2005. Some felt that it may lead to the gradual fall of the EU.
• Increasing German unemployment rate which now hovers in double digits
• Social unrest in France during November
• Terrorist threat post 7/26 in the UK.
The European did not mind putting in their money in foreign country when it is the US. So, the exporters led bonds’ demand coupled with the European factors increased the bond’s prices thus led to the fall in the interest rates of the long term bonds. And the 14% rise of USD against the Euro and JPY each can also be associated with this argument, as the European and Japanese would need USD to buy the US bonds. Hence, among others, increase USD demands against the Euro and Yen led to the rise in the USD this year.
posted by Vikas Maheshwari, CFA at 9:53 PM
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