Guo Yingfeng : "The U.S. Treasury bond Storm" is Profoundly Impacting the Global Pricing of Risk Assets

—By Guo Yingfeng (Associate Researcher, China Center for International Economic Exchanges)

Since September of this year, the yield on the 10-year U.S. Treasury bond, known as the "anchor of global asset pricing," has been rising steadily, breaking through the 5% threshold on October 20, reaching a new high in 16 years. This escalating "U.S. Treasury Bond Storm" continues to impact the nerves of global capital markets. The 10-year U.S. Treasury bond is a core asset in the portfolios of major global investors, and the fluctuation in its interest rate level will not only directly affect the liquidity of major global government bond markets but also significantly influence the pricing of various asset classes, including global stocks, commodities, and foreign exchange, through various transmission channels.

The rise in the yield of the 10-year U.S. Treasury bond reflects three different market expectations: a cooling of expectations for a Fed rate cut, expectations of a sustained high level of U.S. interest rates, and expectations of an expanded U.S. federal government deficit. These three expectations reflect the reasons for the increase in the yield of the 10-year U.S. Treasury bond. First, the macroeconomic resilience of the United States exceeded expectations, with macroeconomic data such as economic growth and employment continuing to rise in September, reflecting that although U.S. inflation is slowing down, it remains sticky. Second, the market turmoil triggered by the increased issuance of U.S. Treasury bonds. According to the U.S. Department of the Treasury website, in the four months since the U.S. suspended the debt ceiling in June, the scale of Treasury bonds has continued to increase by about $1 trillion, reaching a historic high of $33 trillion. Market predictions suggest that approximately $7.6 trillion of low-interest-rate debt is expected to mature in the next 12 months, and the U.S. Treasury Department needs to continue issuing a corresponding amount of bonds. Third, the "hawkish" stance of the Federal Reserve is a direct trigger. On October 19, Federal Reserve Chairman Powell expressed two views in a speech to the Economic Club of New York: the Fed will "proceed cautiously" and retain the possibility of further rate hikes; the current monetary policy is not "too tight" and there is still room for further tightening. However, it is also important to note that the escalating Israel-Palestine conflict has created continued "high tension" in geopolitical risks, causing disturbances in global commodities and other markets, including the bond market. While pushing up energy prices, it will also push down the yield of the 10-year U.S. Treasury bond. The pullback in the yield of the 10-year U.S. Treasury bond after breaking through 5% on October 20 is influenced by these factors.

To assess the trend of the 10-year US Treasury bond yield, it is necessary to consider the Federal Reserve's policy pace regarding the 2% inflation target, and the reasons behind it are complex and variable. Overall, the Federal Reserve's tightening cycle is currently in its final stages, and a rate-cutting cycle is expected to commence after June 2024. On one hand, the high volatility of US interest rates is expected to persist for a certain period due to the rise in energy prices and the reshaping of the manufacturing industry's supply chain. However, it may be challenging to return to the 2% target in the short term. On the other hand, the current level of US interest rates already reflects the extent of tightening in US financial conditions. Powell mentioned on October 19 that "sustained changes in financial conditions may affect the path of monetary policy." There is a high probability of one last rate hike by the end of the year, but no additional hikes are expected thereafter. Additionally, the recent rise in the 10-year US Treasury bond yield is gradually erasing the inversion with the 2-year US Treasury bond yield. It is also crucial to monitor the fluctuation risks of the 10-year US Treasury bond yield, including the risk of a downturn. If the US federal government budget encounters obstacles in the 2024 fiscal year, it could disrupt the economic resilience of the United States and lower expectations for the country's macroeconomic trends. Another risk is the interest rate volatility risk triggered by the financial market risks in the United States. If interest rates rise due to rate hikes, causing a withdrawal risk similar to the Silicon Valley Bank, it could force a shift in the Fed's monetary policy, driving the decline in US Treasury bond yields.

As the 10-year US Treasury bond yield, the "anchor of global asset pricing," has sharply risen, its impact is primarily concentrated on the negative effects on global liquidity. More importantly, from the perspective of valuation and allocation value, it will affect the pricing of risk assets, putting overall pressure on global stock markets, bond markets, and commodity markets, leading to a decline in prices for commodities such as crude oil. Firstly, domestically in the United States, while the US Department of the Treasury is resolving a massive deficit through extensive bond issuance, the Federal Reserve, US banks, and foreign investors are significantly selling US Treasury bonds. This selling pressure intensifies the sharp rise in interest rates, potentially triggering a liquidity crisis. Secondly, it causes disturbances in the bond markets of other countries, particularly in Europe, where German government bond yields have continued to rise to highs not seen since 2011. Thirdly, it may lead to a liquidity crisis in emerging markets. The continuous rate hikes by the Federal Reserve, while tightening domestic monetary liquidity in the United States, also accelerate the outflow of funds denominated in US dollars from emerging markets, increasing the debt pressure on these countries and destabilizing the risk assets in emerging market countries. Fourthly, for commodities, sectors with a high proportion of fixed assets and heavy debt are most affected by the impact of high interest rates, with real estate being the most vulnerable. Gold and oil, major commodities, show a negative correlation with the yield of the 10-year US Treasury bond. These intertwined market trends need to be considered in conjunction with the geopolitical risks brought about by the Russia-Ukraine conflict and the Israel-Palestine conflict. Fifthly, the sustained concerns about the rise in risk-free rates imply that global stock markets will face some downward pressure. On October 20, all three major US stock indices fell, with the Nasdaq index dropping 1.53%. European indices, including Germany's DAX, Ireland's ISEQ, and France's CAC40, all experienced significant declines.

The rise in the yield of the 10-year US Treasury bond has relatively limited negative impacts on China, but it should be taken seriously. Firstly, as a major purchaser of US Treasuries, China should closely monitor the dynamics of the US Treasury market, pay attention to the liquidity issues caused by the continuous rise in the yield of the 10-year US Treasury bond, and formulate corresponding risk management and response strategies. Secondly, attention should be paid to the impact of the rise in the yield of the 10-year US Treasury bond on the Hong Kong stock market, closely monitoring the impact of abnormal northbound capital flows on the domestic stock market. At the same time, effective precautions should be taken against the emotional transmission risk of a global stock market downturn to the Chinese stock market. Additionally, domestic institutional investors need to manage positions in US Treasuries and the US dollar, and consider risk hedging through investments in major commodities such as gold and oil.

(The original article was published on 21st Century Business Herald on 24^th October, 2023)