Is a rebalanced world a danger for US rates?

Good friend Niranjan Rajadhyaksha has an interesting piece in MINT on the diminishing current account surpluses in China and dwindling current account deficits in the US. In other words, one of the big worries, pre-2008, is now fading fast. As he correctly notes, this could have implications for interest rates.

If emerging economies, particularly China, are not running up huge current account surpluses, then they do not have to accumulate reserves and then find a parking place for those reserves in US Treasuries. Consequently, yields on US Treasury Bills, Notes and Bonds would rise. Reasonable conjecture.

Let me clarify upfront: I do not think that this conjecture is wrong. If anything, all of us are waiting to see if the hypothesis floated by Warnock and Warnock back in September 2005 is really a valid one. They had told us that bond buying by Asian and other EM central banks could have depressed bond yields by 75 to 150 basis points in the US.

I have been somewhat wary of flow-based arguments. Bond yields are based on the trajectory of short-term interest rates and inflation expectations. Of course, this is a broad statement of central tendency. However, there could be several idiosyncratic factors that make bond yields a function of other factors, for a period.

After all, purchases by the Federal Reserve might have played a role in holding down bond yields. We do not know if bond yields would have, otherwise, priced in a long-term inflation premium. Of course, the counterargument is that the current inflation rate is hardly a matter for worry, for bond markets.

Nonetheless, since the beginning of 2013, US Treasury Note (10 year) yield has crept up slowly, reflecting the market belief that short rates in the US might rise sooner than what the Federal Reserve had indicated. The Federal Reserve had reassured the market repeatedly that it won’t do so, to the point where it might have boxed itself into a corner from which it cannot extricate itself without damaging its credibility. Any way, we are digressing.

But, the point is that the bond yield has been rising because of short rate expectations despite the steady flow of bond purchases by the Federal Reserve which has taken over from foreign central banks.

So the question is if the bond yield would rise under the twin assault of reduced bond purchases by the Federal Reserve and reduced Reserves Investing by EM central banks. US Government yield curve might rise for a while but it would be shortlived. Ultimately, the crucial determinant would be the direction of short rates in the US.

My guess is that bond yields would drop (unless the Federal Reserve throws caution to the wind and goes for esoteric and dangerous concepts like nominal GDP targeting which, it well might) and stay low as the US economy is in no position to withstand sustained higher rates. There is also the risk of a stock market crash which is positive for bonds in two ways – both from a switch in flows from equities to bonds and from the impact it would have on growth and inflation prospects.

Then, when the US dollar begins to weaken again (perhaps, in the second half of the year?), reserve accumulation and Treasury purchases on a larger scale might resume. However, right now, growth in foreign exchange reserves and their allocation to the US dollar has clearly slowed (see chart).

All told, I am prepared to wager that a ‘rebalanced’ world is no (big and sustained) threat for interest rates. But, I could be wrong and it will be interesting to watch what happens to US bond yields this year.


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