Last Thursday, as expected, the US Federal Reserve hiked the Fed funds rate another quarter per cent, for the ninth time in succession, taking it to 3.25 per cent, the highest level for almost four years.
Over the period, even as the oil price has remained high, US GDP growth has continued strong at 3.7 per cent a year. Curiously, the 10-year bond yield has actually dropped from 4.62 per cent to 3.93 per cent currently. (Still, USD bonds yield more than EUR or JPY bonds.)
The behaviour is puzzling -- so much so that Alan Greenspan, the chairman of the US Federal Reserve, who specialises in keeping the markets guessing, was forced to confess a few weeks back that he is unable to explain why bond yields are so low. Nor, for that matter, has anybody else offered a convincing explanation.
Euro-denominated bond yields have also been falling, but in a different macro-economic environment. First, the European Central Bank has kept the interest rate steady in the face of repeated rises in both the US and the UK.
The fall in bond yields to a level not seen even in the heyday of the Deutsche mark, is the result of slower GDP growth and lower consumption and investment. Flatter or even inverted yield curves are being seen all over the developed world and often presage an economic slowdown, if not recession. The low interest rate scenario is triggering various fallouts:
Even conservative investors like pension funds are being tempted to take riskier bets through alternative investments like hedge funds, private equity, real estate and so on, in order to improve yields. Recently, the US pensions regulator cautioned pension funds against the risks;
Hedge funds are, on the one hand, adopting even more risky strategies than they are used to and, on the other, competing with commercial banks in corporate lending. A recent survey in the US evidenced 50 per cent of the banks being worried about competition from hedge funds!
To cater to demand for higher yields, investment banks are designing high yielding, but obviously higher risk products.
With an increasing number of emerging market economies including India, becoming net creditors to the rest of the world, the bond yield premium on EME debt has narrowed over the past few months -- in fact the cost of raising syndicated debt is the lowest in 8 years for investment grade borrowers.
Corporate bond yields are also low. Goldman Sachs has ascribed the phenomenon to surplus savings with US corporations. Banks are so anxious to lend that they have loosened credit standards. Several commentators are drawing parallels to the LTCM disaster of 1998.
Individuals are being offered mortgage loans with interest alone being payable for five years -- in other words, a monthly instalment of less than $5,000 for $1 million loan! And, zero margins on market prices! No wonder a housing bubble has grown to gigantic proportions.
The result of the consumer borrowing binge is that, despite corporate sector surpluses, the private sector's saving investment imbalance is as high as -- 3 per cent of the GDP!
The enigma of low bond yields is accompanied by another one: the strengthening of the dollar in the foreign exchange market. The US current account deficit in April was as high as $57 billion, and that for the first four months has totalled $229 billion, as against $187 billion in the corresponding period last year.
By any conventional logic, the sheer scale of the deficit is daunting. And, even as the Organisation for Economic Co-operation and Development has predicted a further rise to $900 billion by 2007, the dollar has strengthened more than 10 per cent against the euro since mid-March.
There are apprehensions that at some stage, political pressure for taking trade protectionist measures will start building up, particularly if growth slows.
While such action would contravene the World Trade Organisation rules, it should not be ruled out, given the administration's penchant for defying the world community. But the fact is that inflation has remained benign primarily because of cheap imports, and trade protection would surely add to inflationary pressures.
Overall, the more one thinks about it, the stronger is the feeling that an appreciating dollar and the low interest rates may not persist for long. At least one of the two, perhaps both, will have to give.
As Martin Wolf remarked in the Financial Times, June 13, 2005, "the only industrial countries to have run current account deficits of over 5 per cent of GDP for more than five years have been New Zealand and Ireland. The scale of US current account deficits and prospective liabilities is unprecedented for a large industrial country. To believe that this will be sustainable is to hope that investors are prepared to make an open-ended commitment to holding assets" that carry significant currency risks.
It is worth noting that in both April and May the capital inflows have been less than the current account deficit, rendering the strengthening of the dollar more puzzling. BIS, in its annual report, has warned of the possibility of a rapid and disorderly decline of the dollar.
As Alan Greenspan nears the end of an illustrious career, is he worried about three possible shocks to the financial systems in the near term: a sharp fall of the dollar, a bursting of the house price bubble and a jump in bond yields?
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