Is
Yield Curve Signalling a Downgrade Risk?
There
are many types of bonds ranging from those issued by Government treasuries,
municipal departments to corporations. In simple definition, bonds are IOUs
that strike a lending agreement between two parties based on the mutually
agreed interest repayment to be paid periodically until upon maturity-term. Otherwise,
zero-coupon bonds are those sold below face value but can be redeemed at full
maturity-term with a one-time repayment of compound interest.
Generally
speaking, long-term bonds pay higher yields than short-term bonds owing to
flexibility of tenure by the borrowers. However, there are times when these two
periodic yields go vice-versa and form an Inverted Yield Curve. Unfortunately,
such situation is interpreted as ominous sign when it emerges in treasury-debt
markets. When the yields of these 2-year bonds and 10-year bonds turned flat
during the financial crisis period in Y2007 – 2008, the yield curve signalled
recession that investors were unwilling to lock in their funds for a decade and
also adopting an observation to monitor the U.S. Government’s resolution in
managing the crisis!
With
the increment of money supply by the Obama administration, inflation has been
ballooning in post-crisis period. In contrary to the situation that we
mentioned above, the yield differentials of U.S. treasury bonds have been
running up steeply. From our recent observation, it shows many U.S. economy
data have are pointing to gradual inflation within the economy and thus, interest
rates are rising rapidly in the yields of long-term bonds.
In early
February, the 1-year yield of U.S. treasury bonds traded at 0.74 percent while
the 10-year yield climbed to above 3.6 percent. Investors are worried of an
imminent runaway inflation if FED continues to pump in funds to support
Government’s bonds prices as rescue stimulus. As a result, many bond experts
believe the bloated budget deficit with no clear plans to reduce debt would
jeopardize its AAA-rating of U.S. debt instruments and eventually lead to a
downgrade.
Head of U.S. rate strategy at Bank of
America Merrill Lynch commented that we have never seen these moves when we
have had better economic data in the past with Fed rate hikes on the way. From current outlook, the yield curve is
flashing “concerns about an unsustainable fiscal deficit and an eventual
potential ratings downgrade”.
Some
investors are starting to demand higher rates of return for holding
longer-maturity Treasuries to compensate them for the risk that U.S. sovereign
debt could be downgraded. The consequences of a U.S. credit-ratings downgrade
could devastate the economy, pushing up borrowing costs and threatening the
Dollar. The concern of a downgrade is likely to grow over the upcoming years if
U.S. Government is unable to find a solution to reduce its external debts and
federal deficits.
At
current rate, the U.S. has incurred an external debt USD13.98 trillion as of
June 2010 and public debt estimated at 60 plus percent of national GDP about
USD14 trillion in Y2010. In our opinions, the U.S. Government is stuck in a
stagflation consisting of raising inflation but subdued growth. As FED might
inject more liquidity into bonds markets, ballooning deficits are causing fear
among investors of downgrades in credit ratings. If the housing mortgage rates
go up to higher above 6 percent by trailing the long-term bonds yield, housing
markets will deteriorate and hard to recover from the crisis slump!
For
instance, Japan was stripped of its AAA status by Moody’s in 1998 and Standard
& Poor’s in 2002 and downgraded to AA rating. On 27 January, Standard &
Poor’s (S&P) cut Japan’s long-term sovereign debt rating by one notch to AA-
again and signalled risk in investing with Japan’s long-term sovereign debt. However,
Japan’s bonds market reacted calmly. With its federal deficits about 200
percent of GDP, the fatigue economy does not qualify to sustain higher yields
but the near-zero short-term rates has put Japan in recession for many years.
In
month of January, both Moody’s and S&P warned that the U.S. could be
downgraded if it does not make progress in shrinking the debt level in next two
years. Will U.S. economy mimics Japan into a financial decade if it does not
contain the federal deficits in this new decade?
Observe
the yield curve and find out the answer in these coming years.
Henry
Seet is a protégé and certified coaching master of DAR Wong. The expressions
expressed are solely theirs. They can be reached at www.traderpromaster.com
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