RISING TREASURY YIELDS
Investors are getting anxious on the impact of rising bond yields on inflation and economy.
One of the most talked about topics in the financial market recently is the rebounding of the 10-year U.S. Treasury yield. Last March, the yield on the 10-year Treasury fell to lows of 0.5% as risk adverse investors reacted to the full implications of the Covid-19 pandemic. Since bottoming in August last year, the Treasury yields have risen by more than 100 basis points, reaching 1.59% as of 9 March. Despite the yield remaining at its lowest since the World War II period, the rising trend draws market attention, particularly since February when President Joe Biden’s US$1.9 trillion America Rescue Plan was on the cards.
Debates have been stirring among liberal economic titans as to whether the US$1.9 trillion plan is too huge vis-à-vis the output gap that will unavoidably bring about inflation rates not seen since 1970s. The rising U.S. Treasury yields may just be a prima facie of market inflationary consensus.
In addition, the approved U.S. debt financed Rescue Plan is expected to flood the bonds market with the supply of safe assets, pushing the U.S. bond yield further up.
Implication on Malaysian bond market
Should the spread between the emerging market risk-adjusted bond yields and the U.S Treasury yields shrink, the diminishing attractiveness of emerging market bonds is likely to result in a portfolio reshuffling towards U.S Treasury bonds. It is not hard to see then the inevitable course of events – either emerging market bond yields head north, or the dollar value of the currency heads south, or a mix of both.
Which brings us to the case of Malaysian 10-year government bond or securities (MGS) yield that seems to be following this trajectory.
The 10-year MGS yield slid to a historically low level of 2.5% in July 2020, and gradually recovered to 2.7% in the next six months. But the MGS yield has rose rapidly since February to breach 3.29% at the end of the first trading week of March. And the ringgit also shows sign of weakness vis-à-vis the U.S dollar.
The continuous rise of long-term bond yields requires serious attention for four reasons:-
Firstly, as sovereign bond yields climb, corporate bonds would also see their interest rates rising. This will lead to increasing external borrowing costs that could dampen the pace of economic recovery.
10-Year U.S. Treasury Yield Historical Lows
On July 25, 2012, it closed at 1.43, the lowest point in 200 years. Investors worried about the eurozone debt crisis and a poor jobs report.
On July 5, 2016, it set another record low at 1.37%. Investors were concerned about the United Kingdom’s vote to leave the European Union.
It closed at a record low of 1.33% on 25 Feb 2020 and continued falling, setting new record lows along the way. By 9 March, it fell to 0.54%. Investors rushed to safety in response to the uncertain impact of coronavirus pandemic. It subsequently recovered throughout the year, and surpassed 1% in early 2021.
Secondly, it reflects market consensus on a potential return of inflation. The recent rally in oil and commodity prices, as well as a strong bounce back of base money growth rates, would have reinforced such inflationary expectation.
Thirdly, although equities are a good hedge against inflation, longterm yields that resume their climb could erode the present value of future corporate profits, creating pressure on stock valuations.
Lastly, when long-term borrowing becomes expensive, the federal government will be incentivised to issue more short- and medium-term bonds, tilting the overall debt maturity structure away from long-term bonds, thereby hurting the soundness of public debt.
For policymakers, what can be worse than an economic growth recovery that loses steam, with inflation threatening to rear its ugly head, and the soundness of public debt that starts to weaken, all happening concurrently?
If policymakers raise monetary policy rate to curb inflation, while economic growth momentum is disrupted, fiscal capacity could be squeezed following the rise in public debt servicing cost. All these in turn will hurt the economy further.
But doing otherwise may not be good either. Monetary inaction in the face of inflationary environment resembles adding fuel to the fire, only delaying the inevitable.
Certainly, challenges faced by the fiscal authority are no less daunting. Untimely fiscal consolidation that hurts economic growth recovery is self-defeating, while delayed fiscal consolidation would contribute to spikes in long-term Treasury bond yields.
Adopting a fiscal-monetary policy mix that is conducive to economic growth, harmless to inflation, and helps reshape public finances therefore has become extremely important.
More worrying is the fact that the 10-year MGS are now discount bonds, as the transaction yield has been higher than the coupon rate for quite some time. This is different from the short and medium-term bonds that are still premium bonds.
This perhaps points to the beginning of the market doubting the long-term fiscal solvency for Malaysia, which could be disastrous if the sentiment turns from being doubtful to pessimistic. To tackle the situation, configuring a reform in our tax system and public expenditure is a path we must take in the next five years.