Special Report-US bond yields highest since last June

Posted by admin as Forex News

US 10 year bond yields traded at the highest level since June 2009 reaching a yield of 3.94% last week. The credit crisis sent ten year bond yields to a record lows in December 2008 as investors sought safety in US treasuries and the Federal Reserve lowered the Fed funds rate to a record low. The worst of the credit crisis has passed and bond yields are rising. Are bond yields rising because of optimism about the US recovery or because of concern about rising US debt? The answer to this question may be crucial to the outlook for the USD.

 The US government reported a record $221bln monthly budget deficit in February. February marked the 17th straight month that the US government has posted a deficit. The Obama administration is forecasting 1.56trln deficit for 2010. US government deficits are projected at 1trln or more through 2020. Last week the U.S. Congress passed a health reform bill. The estimated cost of the health reform bill is just under 1trln over the next 10 years with the CBO estimating that the reform bill could reduce US budget deficit by close to $200bln in the next decade. Many analysts are skeptical that the health reform bill will reduce the deficit and warn that the health care bill could cost more than the government estimate. This may partly explain why it might not have been a coincidence that US ten year yields hit their highest level since last June after the announcement of the passage of the health reform. Additional deficit concerns include report that the US Social Security administration will for the first time pay out more this year than it takes in and last week the Obama administration  unveiled  new measures to help the unemployed reduce their mortgage payments. The revamped mortgage plan will expand the administrations $75bln foreclosure relief effort but it’s not clear by how much.

 US bond yields have been rising because of weak demand for US bond auctions sparked by increased bond supply and investor concern about the rising US deficit. Last week’s US bond auctions were poorly received with reduced demand from foreign central banks. Ten-year bond yields posted their biggest weekly jump last week since December. The Greek debt crisis, Dubai World debt restructuring and sovereign debt risks in the UK and Japan may have dampened demand for US bonds forcing investors to shine a light on US fiscal troubles. According to the CBO, US debt will rise to 90% of GDP and that the 2011 fiscal budget would generate $10trln cumulative budget deficits over the next 10 years. The rise in GDP debt ratio could weaken US long-term growth outlook and force investors to demand higher yields to buy US debt.

 Over the past few months China has been reducing its holding of US treasuries. China and Japan are the two largest holders of US debt. Indirect bidders at last weeks US seven year note auction declined to 41.9% compared to 49.7% in the last four auctions. Indirect bidders include foreign central banks. Diminished demand for US treasuries by foreign central banks could lead to higher interest rates and higher cost for the US funding of its deficits. The function of the market is to discipline governments. The spike in US yields may be the first sign that the US government is spending too much and that the Fed has maintained low yields for too long. At the same time that the US federal government is posting record monthly deficits many US state governments are falling deeper into the red. State governments will be competing with the federal government to raise capital and this could add additional upward pressure to yields and eventually crowd out investors. The US may find it more difficult to fund its debt.

 Bond yields may also be rising because of optimism about the US recovery. Although recent US economic data has been mixed, the Federal Reserve Board raised its economic outlook for the US economy and begun laying the foundation for an eventual exit from accommodative monetary policy. Optimism about the US recovery is fueled by report of strong US Q4 GDP. US Q4 GDP grew by 5.6%.Most of the Q4 GDP growth was due to rebuilding of inventories.Q4 consumer spending was weak. The rebound in GDP may not be sustainable without increased consumer spending. US GDP is expected to grow by an average of 3% in 2010. This would be respectable growth but not strong enough to send yields surging because US inflation is subdued. In addition, US equities are trading at an 18 month high. The strength of the equity market rally is seen as further evidence of optimism about the US recovery. This Friday’s release of US March unemployment will be key to investor optimism about the US recovery. The March nonfarm payrolls report is expected to show significant improvement. Fed policy has been closely tied to the US employment outlook. Once jobs growth becomes self-sustaining the Fed is likely to hike interest rates.

 A number of analysts expect the recent rebound in the US economy to slow in the second half of the year as consumer spending remains weak, fiscal and monetary stimulus is withdrawn and unemployment remains elevated. If bond yields continue to rise it could add additional risk to the strength of the recovery. The USD is trading at its best level versus Europe in ten months and a two month high versus the JPY. The USD is benefiting from the rise in US bond yields. If yields continue to rise solely because of investor concern about US fiscal outlook and growth slows the USD may experience fresh selling pressure. Note in the graph below that US ten year yields are approaching the high end of the recent range at 4.20%. A break above this level could set off alarm bells about the US deficit. Rising bond yields could become a negative for the USD if yields are rising because the US is borrowing more than it can repay.