Global Bond Yields and Asset Prices - vrk100 - 07Jul2022

Global Bond Yields and Asset Prices

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(An update 15Dec2022 is available)

 

Asset prices hinge on future cash flows of the asset and discount rate.

 

The discount rate is the sum of the risk-free rate, expected inflation rate and a risk premium specific to the asset’s expected cash flows. For long-duration assets, like, growth stocks, the risk-free rate is the 10-year sovereign bond yield. As the risk-free interest rate is a component of the discount rate, whenever interest rates go up, the discount rate increases and the asset price falls, provided other things remain unchanged. 

 

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Related

Global Bond Yields Surge 05Mar2022

Global Bond Yields and Interest Rates 29Nov2021

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Bond yields, especially sovereign bond yields, are the building blocks of asset pricing. It's not a good idea to look at any single market in isolation. The bond, equity and forex markets are inter-linked; not to speak of global linkages. In markets, everything is connected—wars, virus outbreaks and supply chain disruptions.

 

Fiscal and Monetary Stimulus

 

The world over, both the monetary and fiscal authorities have been following unconventional policies--with the result asset prices are not reflecting their true fundamentals. In the US, the federal government had pumped in massive doses of economic support to the citizens who were impacted by the COVID-19 Pandemic.

 

This monetary and fiscal stimulus had propped up asset prices globally. Such artificial prop-up of financial markets led to less efficient price discovery of asset prices--creating its own problems for the global economy.

 

With following ultra-loose monetary policies for several years, central banks globally have distorted asset prices. With such distortions, investors should not assume that asset prices correctly reflect their true fundamentals.

 

With central bank-led asset price distortion, behaviour of economic agents changes, which is detrimental to the economy as a whole. Investors / speculators tend to look for easy and quick returns, speculating in stock or crypto-currency markets. With fixed income giving negative real rates, investors are forced to stick to risky assets even though price discovery mechanism of risky assets is in smithereens thanks to relentless bond buying (also known as quantitative easing or QE) by global central banks.

 

With interest rates near zero globally due to the unconventional monetary policies followed by major central banks for long, asset prices had remained elevated globally. That was before the start of 2022.

 

Since the beginning of 2022, investors started to price in steep rise in interest rates (especially in the US and the UK) and global stocks had started falling steeply. As inflationary pressures (aided by Russia’s invasion of Ukraine, rising crude oil prices and global supply chain bottlenecks) remained elevated, major central banks, like, the Federal Reserve, Bank of England and others started raising their benchmark interest rates (details in Table 2 below).

 

Investors were extrapolating asset prices in financial markets would only grow higher. But with rising inflationary expectations, investors’ assumptions of financial conditions had changed dramatically in the past six to eight months, leading to steep fall in global stocks, except those in the energy sector.

 

Disconnect between Inflation and Interest Rates

Before the advent of Quantitative Easing (QE) monetary policies, there was a close resemblance between inflation and interest rates. Whenever inflation rises and falls, interest rates used to rise and fall together. There was not a big difference between inflation rates and interest rates.

 

But post-QE, the situation is different. Have a look at the interest rates and inflation numbers provided in Table 3 below. For example, the consumer price inflation (CPI) in the US is 8.60 per cent (latest available print), but the Federal funds rate at 1.50-1.75 per cent is way below the inflation rate. It is not clear how the Fed will be able to control inflationary pressures with such massive difference between inflation and interest rate.

 

The distortion is worse in the Eurozone. The European Central Bank (ECB) has kept interest rate steadfastly at zero for a long time, whereas the CPI is elevated at above 8 per cent in the Euro area. Such distortion is not helping anyone. This kind of distortion is reflecting in currency market with the Euro plunging to its 20-year low against the US dollar (one Euro is now quoting at 1.02, close to par, versus the USD). 

 

The US 10-year Treasury Yield

 

Due to the rising interest rates and higher inflationary expectations, the US 10-year Treasury yield rose by almost 200 basis points during 2022. The 10-year yield rose from a level of 1.51 per cent at the end of December 2021 to a recent peak of 3.48 per cent on 14 June 2022. Since then, the bond yield started falling and now is at 2.90 per cent (end-06Jul2022).

 

So, in the past three to four weeks, global stocks stopped their downward journey and started rising once again, though they are still down on a year-to-date basis. 

 

To sum up, asset prices and bond yields are closely inter-connected. As asset price discovery has suffered heavily due to unconventional polices, current asset prices are not reflecting the actual fundamentals. It's time global central banks stopped such price distortions and halted stimulating the economies artificially for too long.

 

The following tables provide data on global bond yields, central bank interest rates and inflation rates:

Table 1: Global 10-year Bond Yields - how they changed between Dec2021 and Jun2022 >

Table 2: Global Interest Rates as of 30Jun2022 >

Table 3: Global Bond Yields, Interest Rates and Inflation Rates >

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P.S.: The following images are added after the above post is published, with information on global bonds datas as of 30Sep2022 > World GDP, inflation rates, interest rates and 10-year gov't bond yields > Images from Trading Economics >

 

   

References:

 

 Bond yields raw data as on 30Jun2022 >

 

Tweet 09Nov2020

 

Tweet 18Oct2020

 

Tweet 12Oct2020

Tweet 11Aug2020

 

Tweet 11Aug2020

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Disclosure:  I've vested interested in Indian stocks and other investments. It's safe to assume I've interest in the financial instruments / products discussed, if any.

Disclaimer: The analysis and opinion provided here are only for information purposes and should not be construed as investment advice. Investors should consult their own financial advisers before making any investments. The author is a CFA Charterholder with a vested interest in financial markets. 

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The US Fed Raises Discount Rate-Why Did They Do It?-VRK100-28022010

The US Fed Raises Discount Rate-

Why Did They Do It?

Rama Krishna Vadlamudi                    February 20th, 2010


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On February 18^th, the US Fed has given a mild surprise to the financial markets by raising the discount rate by 25 basis points from 0.50 per cent to 0.75 per cent. This is the first major move by the US Fed as part of its exit strategy. Reacting strongly to the Fed move, the US dollar has rallied against the Euro and Pound Sterling. The dollar hit a nine-month high against euro with the euro quoting at 1.35 on Friday. The Euro’s recent high was 1.50 against the US dollar in December 2009. The dollar rallied against the Japanese Yen and pound sterling also – the Yen weakened up to 92 while the pound depreciated to a level of 1.55 against the dollar. The stock markets reacted negatively to the discount rate hike and major indices across, the US, Europe and Asia-Pacific witnessed cuts in the range of one to two per cent on Friday.

While raising the discount rate, the Fed has indicated that this is a not a signal for modifications in the outlook for the economy or the monetary policy. Several policymakers does not want to dub this as a withdrawal of stimulus, rather they would love to call it as a “normalization process,” a new word they designed for their latest actions as these financial systems seem to have come out of the crisis situation.

What inferences can be drawn from the hike in Discount Rate?

1. It seems to be the end of cheap money. Till now, investors used to resort to dollar carry trade by borrowing from the US market at zero or near zero interest rates and invest in commodities or stock markets of emerging economies. This is the serious beginning of an exit strategy from the Fed.
2. There is a marked upturn, however fragile it may be, in the US economy and as such the US Federal Reserve is more confident about the sustainability of US recovery in the next three to four quarters
3. However, Ben Bernanke, the US Fed Chairman, has stated that the interest rates will remain “exceptionally low” for “an extended period of time.” It means that the Fed may not raise the all-important benchmark Federal Funds Rate (Fed Rate) for the next three to four quarters as the US unemployment is hovering close to 10 per cent even now.
4. Even though the US fed funds rate is kept near zero, the Fed has started to unwind other unconventional liquidity measures on an ongoing basis
5. This confidence about the US recovery is good for the  US dollar and the optimism is already showing in the strength of US dollar against euro and pound sterling with the US dollar index hovering around 80 as of now
6. The strong dollar could also be a dampener for the prices of commodities in the short-term. However, the inverse correlation between the commodities and the US dollar may come to an end sooner than later.

What is US Discount Rate?

It is the rate charged by the US Fed for the banks who require emergency money for their short-term requirements. It is similar to the Repo rate in India – it is the rate at which commercial banks in India borrow funds from the Reserve Bank of India for their short-term, usually one or two days, needs.

However, the discount rate does not directly affect the borrowing rates for companies, customers or mortgage rates in the US. As such, the hike in discount rate is as merely symbolic with no impact on interest rates in the economy.

What is the difference between the Fed Funds rate and discount rate?

The Federal funds rate (or simply known as Fed rate) is currently pegged at between zero and 0.25 per cent. The Fed sets the Fed funds rate also. It is the benchmark rate at which banks lend to each other. The federal funds rate is an overnight lending rate among banks/financial institutions in the US. The rate is also used as a benchmark rate by banks to fix interest rates for other loans, like, mortgage loans, business loans, consumer loans and loans to credit card holders. The US Fed uses the federal funds rate as a tool to balance its objectives of economic growth and price stability. Whenever inflationary expectations are high in the economy, the US Fed tries to control inflation by hiking the fed funds rate. On the other hand, if there is a slowdown in the economy, it will try to inflate the economy by lowering the fed funds rate.

The Fed funds rate is similar to the call money rate through which Indian banks lend or borrow among themselves to meet their short-term funds requirements or lend their short-term surplus funds to other needy banks. However, the RBI has no direct control over call money rates in India. They are purely driven by supply of and demand for money among the commercial banks and primary dealers.