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What the Historic Crash in Bond Markets Means for Forex

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There has been a lot going on in the world lately to fill up headlines, so that some important things might be slipping through the cracks. That seems to be the case with the rise in US bond yields over the last several months that have come close to a tipping point. Earlier this week, US Treasury Secretary Janet Yellen had to come out to address the issue in the hopes to calm the markets.

The last time the price of bonds was a major issue for the markets was when several banks collapsed back in March. The Fed put in what amounted to an indefinite backstop to the banking system to correct this problem. But the issue keeps growing, and it might be only a matter of time for the next thing to break and roil up the markets. Or precipitate the recession that investors are starting to forget about.

What’s going on?

Back in July, the Fed stopped hiking interest rates. They say they might do one more hike in the coming months, but that’s it. However, in the meantime, the yield on US debt has continued to rise, and accumulated almost 100bps since then. This is not how things are supposed to work. Yields are expected to rise and fall according to the rate that the Fed sets. Now we have a situation where interest rates are rising while the Fed isn’t intervening in the market.

Bond yields are at their highest level since 2007, right before the sub-prime crisis. The price of benchmark US 10-year treasuries has fallen by 46%, the largest drop in history. Thirty-year bonds have fallen 53%, also the worst performance since the US government started to issue debt over 240 years ago.

What does this mean for financial markets?

The bond market is where the money that finances the markets is stored. US Treasuries are seen to be as tradeable as cash, but offer the advantage of paying interest. So virtually all money in the US financial system that isn’t being used for something else (like buying stocks) is tied up in the bond market.

The value of those bonds have nearly halved in a little more than a year, which is a problem for anyone who put money aside in “safe” investments. Bonds offering a higher rate of return mean it’s a better investment to buy bonds than stocks. This means funds for stock investment are drying up.

The impact on forex

In the very short term, it means that the value of the dollar goes up. Higher interest rates make holding dollars a more attractive proposition than other currencies, which have negative real rates of return. This weighs on the price of gold and commodities, as well.

But beyond the short-term, the higher cost of debt in the US would be seen as a major drag on the economy, and could push it over into a recession. In a more extreme scenario, the lack of liquidity from people buying and holding bonds could push the stock market into a crash, which could also precipitate a recession.

Yields are rising because investors are increasingly worried that the level of debt the US government has means it might not be able to secure enough borrowing in the future. With the government potentially heading to another shutdown next month, the pressure on yields would likely continue to grow, and exacerbate the problem. That could be good for the dollar, as long as nothing breaks. The problem is, just like with the banks back in March, it’s hard to know ahead of time where that break will happen – and whether the Fed can come up with another unprecedented policy as a patch.

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