Forex markets are on alert for a phenomenon that’s going a bit under the radar, but is one of the key drivers of currency pairs. There has been a global shift in bond yields (the interest paid on bonds) as forex traders evaluate diverging outlooks among major central banks. Although the trend is higher, with several issuances hitting record highs, there is a wide variety of reasons which could lead to increased volatility in currency markets.
The 30-year US Treasury yield rose to its highest level in almost a year, while the benchmark 10-year bond hit its highest level in 15 months. The situation is even more dramatic overseas, with the German benchmark hitting highs not seen since 2011, and Japanese Government Bonds (JGB) hitting highs not seen since early 1997. The situation is also concerning in the UK, where 10-year gilts hit their highest level since the Great Recession, exceeding the level during the “mini-budget” crisis that ended the Truss government. This is notable given the ongoing uncertainty around the premiership of Kier Starmer.
Political and Spending Issues
A common denominator is that long-term yields have been rising to record levels not seen since the ’90s in Europe and Japan. Typically, long-maturity bonds, such as 30-year bonds, are most sensitive to political issues and reflect investors’ confidence that the government will be able to manage its finances. Amid the geopolitical stresses in the moment, such as the war in the Middle East, and trade tensions between the US, China and the Eurozone, that is understandable. But what’s more relevant to traders is where the trend is going.
Investors demand higher returns on bonds when they are worried about the currency’s underlying value. If inflation rises, then the real return on the bonds falls. Therefore, their yield has to rise to compensate. Higher energy prices are a catalyst for higher inflation, and that is pushing up yields. But the rise is from an already high baseline, as investors worry about government spending.
Government Spending Disrupts Forex
Not surprisingly, the yields reaching the highest levels are in places like the UK and Japan, where there is considerable political debate over raising spending. Increased government expenditure without a commensurate rise in economic growth means an expansion of the monetary base, and, by extension, inflation. Investors are worried that these countries will face prolonged, significant inflation and are raising the premiums they demand for holding debt.
Normally, when yields rise, the currency increases since the higher interest rate offers a better return on investment. But if yields are rising due to inflation fears, the erosion of value from inflation undermines the benefit of higher interest rates. This causes the currency to move in the opposite direction and weaken compared to economies which are expected to have less inflation.
The Market Outlook
One way policymakers can address the problem is for the central bank to raise rates. At the start of the week, G7 Finance Ministers and Central Bankers met to discuss the yield issue, and resolved to not to take coordinated action – yet. That means each country has to balance its spending and interest rate policy, which could lead to variation in the currencies.
If central banks take a more hawkish position, it could restore investor confidence that inflation won’t get out of hand. Long-term rates would fall and support the currency. That is, if the rates don’t rise too much, too fast and stifle the economy, which would weaken the currency. Overall, countries with more economic growth are in a better position to deal with the problem, and could see their currencies strengthen in the coming weeks and months.
