Yield inversion, Soft-landing and Reverse Currency wars

In News

• Recently, with the US inflation rate at 9.1%, the highest in 40 years, it is significant to take a look at these key terms.

Background

• Inflation in the US: the inflation rate for June came in at 9.1 per cent. This is the highest in 40 years in the US.
  • There is a rapid increase in interest rates by the US central bank.
• Inversion of the US yield curve: it is to argue that the US central bank will not be able to achieve a soft-landing for the economy.
  • Yet the US dollar continues to gain against all other currencies.
• Reverse currency war: most central banks across the world are trying to raise their interest rates to counter the Fed’s actions and ensure their respective currency claws back value against the dollar.

Bond yield curve inversion

• Bonds are essentially an instrument through which governments (and also corporations) raise money from people.
• Risk-free interest rate: Typically government bond yields are a good way to understand the risk-free interest rate in that economy.
• The yield curve is the graphical representation of yields from bonds over different time horizons.
  • In other words, if one was to take the US government bonds of different tenures and plot them according to the yields they provide, one would get the yield curve.
• Under normal circumstances: any economy would have an upward sloping yield curve. That is to say as one lends for a longer duration or as one buys bonds of longer tenure one gets higher yields.
  • If one is parting with money for a longer duration the return should be higher.
  • A longer tenure also implies that there is a greater risk of failure.
• Inverted curve: bonds with tenure of 2 years end up paying out higher yields than bonds with 10 year tenure. Such an inversion of the yield curve essentially suggests that investors expect future growth to be weak.
  • When investors feel buoyant about the economy they pull the money out from long-term bonds and put it in short-term riskier assets such as stock markets.
  • In the bond market the prices of long-term bonds fall, and their yield rises.
  • This happens because bond prices and bond yields are inversely related.

Implications of Bond yield curve inversion

• Pull out money: When investors suspect that the economy is heading for trouble, they pull out money from short-term risky assets such as stock markets and put them in long-term bonds.
  • This causes the prices of the long-term bonds to rise and their yields to fall.
• Strong predictor of recessions: inversion of the bond yield curve has become a strong predictor of recessions.
  • Such inversion is happening repeatedly in the US suggesting many that a recession is in the offing.
• Currently, the US Fed has been raising short-term interest rates which further bumps up the short-end of the yield curve while dampening economic activity.

Soft-landing

• Increasing the interest rate: The process of monetary tightening that the US Fed is currently unveiling involves not just reducing the money supply but also increasing the cost of money that is the interest rate.
• Soaring inflation: The Fed is doing this to contain soaring inflation. Ideally, the Fed or any central bank doing this would like to bring about monetary tightening in such a manner that slows down the economy but doesn’t lead to a recession.
• Soft-landing versus hard-landing: When a central bank is successful in slowing down the economy without bringing about a recession, it is called a soft-landing in which no one gets hurt.
  • But when the actions of the central bank bring about a recession it is called a hard-landing.

Implication of Soft-landing

• Fears of hard-landing: Given the massive gap between the current US inflation rate over 9% and the Fed’s target inflation rate 2%, Experts expect that the Fed would have to resort to such aggressive monetary tightening that the US economy will end up having a hard-landing.

Reverse Currency War

• Investment and Dollar becoming stronger: A flip side of the US Fed’s action of aggressively raising interest rates is that more and more investors are rushing to invest money in the US.
  • This has made the dollar become stronger than all the other currencies. That’s because the dollar is more in demand than yen, euro, yuan etc.
• Currency war: In the past the US has often accused other countries of manipulating their currency and keeping its weaker against the dollar just to enjoy a trade surplus against the US. This used to be called the currency war.
• Every central bank today is trying to figure out ways to counter the US Fed and raise interest rates themselves in order to ensure their currency doesn’t lose too much value against the dollar.

Implications of Reverse Currency War

• Exports: this should make all other countries happier because a relative weakness of their local currency against the dollar makes their exports more competitive.
  • A Chinese or an Indian exporter gets a massive boost.
• A stronger dollar has had a key benefit: importing cheaper crude oil. A currency which is losing value to the dollar on the other hand finds that it is getting costlier to import crude oil and other commodities that are often traded in dollars.

Source: IE