Yielding trouble

Rising bond yields can create risks

Increasing bond yields across various countries are making both financial markets and policymakers anxious. The 10-year government-bond yields reached 3 per cent in Japan this week, the highest level since 1996. Bond prices and yields are inversely related. Borrowing costs in the United Kingdom have increased to a multidecade high. The 30-year bond yield is approaching 6 per cent. The United States (US), which is partially responsible for driving up yields everywhere, has also seen a large selloff in the debt market. Longer-end bond yields are also inching up in India, with the 10-year paper touching 7 per cent this week. Higher yields push up financing costs for both the government and the private sector. A sharp increase in market rates can significantly increase solvency risks for leveraged entities.

 

There are various reasons for the selloff in the debt market. The most obvious is the Iran war. The recent flareup in tensions has again pushed up prices of crude oil, which will likely increase inflation rates across the world. Consequently, investors are demanding higher returns. It is not clear how long the war will last, which is making investors reluctant to commit long-term money. Further, rising government debt too is making investors nervous. The US government debt stock, for instance, recently crossed the psychological level of $40 trillion. Some investors believe that finances of the US government are on an unsustainable path. The US debt stock, according to the International Monetary Fund’s projections, is expected to increase from about 124 per cent of gross domestic product in 2025 to 142 per cent in 2031. The US Treasury department recently proposed a higher buyback of long-dated bonds, which did not go down well in a section of the market. The US Treasury department also recently joined the Japanese authorities to prop up the yen and prevent Japan from selling its holding of US government bonds, which would have further increased yields.

 

Besides, a new chairman at the Federal Reserve and a sudden shift in the US central bank’s communication style are also making markets uneasy. Kevin Warsh, in his recent much-anticipated Jackson Hole speech reiterated the Fed’s commitment to the 2 per cent inflation target. The inflation rate has been above target for over five years, and the Fed might need to raise interest rates, which would further push up yields. Sustained investment in artificial intelligence-related capacity is also driving up demand for funds and raising interest rates. Increasing investment in artificial intelligence, which is being partly funded by debt, can create new vulnerabilities if returns on investment remain below expectations for a longer period. In fact, rising yields themselves can lead to the kind of outcomes that financial markets may not be prepared to handle. For instance, there are reports of a possible unwinding of the yen carry trade because of higher yields in Japan. Since Japan had near-zero interest rates for a long time, investors borrowed in Japan to invest in other jurisdictions. The unwinding of such investments could affect asset prices, including government bonds.

 

Higher global yields or borrowing costs are not good news for emerging-market economies such as India, which depend on foreign investment. Bigger Budget deficits and higher investment demand in the developed world are likely to absorb a higher level of global savings and affect flows to developing countries. India’s experience over the past couple of years confirms this. Thus, it will need to become more competitive to attract foreign investment. Better than expected inflows under the Reserve Bank of India’s swap scheme will help India address immediate challenges on the balance of payments, but they are not a substitute for foreign direct and portfolio investment.