Rising US Treasury Yields and Falling Dollar

Rama Krishna Vadlamudi vrk_100@yahoo.co.in

MUMBAI
May 30th, 2009

It is getting curiouser and curiouser to use a phrase from “Alice in Wonderland.” While US
Treasury yields are rising, the US dollar is falling day by day. And commodities also appear to be
bullish, with crude oil touching more than USD 66 a barrel and gold touching USD 980 an ounce
this week. Even as dollar is on a downward spiral, the US stock markets are still in the most
resurgent mood. While Dow Jones is hovering at 8,500; the S&P 500 broader index is well above
900 levels. The US dollar index (a measure of US dollar versus six other major currencies) has
reached a level of 79.22, though much above its one-year low of 71.72 attained in July 2008 (its
year-high was 89.29 – March 2009). What is the real connection between all these different
markets and reference points? What are the inter-linkages that keep them move in directions
sometimes divergently and another time in the same directions?

According to EPFR Global, the Emerging Market equity funds have attracted a total inflows of
USD 21 billion in the past 11 weeks; whereas, the US, Europe and Japan have seen outflows of
USD 14 billion. The biggest beneficiaries of these global fund inflows are China, Brazil, India and
Taiwan. Obviously, investors are pulling out their money from Europe, Japan and the US as these
countries are sliding into a recession (some are already in recession), though some market men
believe that there are some signs of economic recovery in these countries.

US Bond yields on the ascendant:

Risk appetite for equities has gone up in the last three months the world over. As such, it appears
that money has moved from the so-called safe instruments, like, government bonds into riskier
categories, like, equities and commodities and this is showing in higher levels of stock and
commodity indices. As the prices of US Treasury notes are falling, the yields are touching multi-
month highs (bond prices and yields move in opposite direction). The yield on benchmark 10-year
Treasury note has risen from a level of 2.08 per cent (December 2008) to the present level of
3.67 per cent, an increase of more than 150 basis points in less than six months, which is quite
unusual in the US markets. The massive US government bailout programmes and the
accompanying fiscal deficits have been bothering the financial markets and as such US bond
prices are falling; and moreover, all these developments have put tremendous on the US dollar,
which has lost more than 10 per cent against major currencies since March 2009.

PARTICULARS US TREASURY US TREASURY REMARKS

10-year yield % 30-year yield %
Latest 3.67 4.54 As on May 28, 2009
All-time high 15.84 15.21 On Sep 30, 1981 & Sep 26, 1981
All-time low 2.08 2.53 On Dec 18, 2008

Note: Data for 10-year yield available since 1962 and for 30-year since 1977. (Date source: US Fed)

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Parallel with the early 1980s US economy?

As the table given above indicates, the US in the early 1980s was in the throes of rising
unemployment, skyrocketing inflation and record high level of bond yields. In fact, the 10-year
bond yield touched an all-time high (since 1962) of 15.84% in September 1981. Commercial
interest rates in the US had jumped to more than 20% in the early 1980s. The US unemployment
rate rose to more than 11% by the end of 1982. The US had suffered with soaring inflation
between 1979 and 1985. It would be instructive to analyse the developments at that time. The US
economy was faltering in the late 1970s. In January 1979, crude oil prices went through the roof
after Ayatollah Khomeini dethroned the Shah of Iran. In 1980, Iraq had invaded Iran and their war
on the waters of Shat al-Arab in the Persian Gulf caused massive supply disruptions and oil
prices shooting up dramatically. From a level of USD 14 a barrel in 1978, oil price surged to more
than USD 35 a barrel (nominal prices), a phenomenal increase of more than 250 per cent by
1982. After becoming chairman of the US Fed in July 1979, Paul Volcker followed a policy of
“slaying the inflation dragon” and raised interest rates in order to constrict money supply in the
style of Milton Friedman. These measures failed to control the inflation monster quickly and revive
economic growth. The economy was put on the growth path only after president Ronald Reagan
offered massive tax cuts and deregulated the financial markets in a big way, among other things.

In the highly adventurous world of financial markets, funny things occur many a time. Depending
on the reference point we take, the data of various markets throw up interesting insights into
correlation and divergence. The past data about oil price suggests that it is not correct to think
that oil price goes down during times of economic recession. In fact, in the 1970s, when the
economies of the US and several other countries were in recession, the oil price went up by 15
times (Jim Rogers). Ultimately, the principles of demand and supply rule the roost.

China and the US: Siamese twins?

China has expressed its concern about the falling dollar recently. They have suggested that the
world needs to replace the dollar with another reserve currency, which has been endorsed by
other countries. However, it is difficult to believe that China will push for an alternative reserve
currency very hard as its economy is closely dovetailed to the US economy. The US consumer
spending had fed export-oriented Chinese economy for decades. In turn, China has been
responsible for bridging up the massive budget deficits of the US by investing its (China’s) forex
reserves in the US Treasurys. That way, the economies of the US and China are conjoined twins.

Investors need to ask themselves the following questions in the months to come:
1. When will the US Fed start raising interest rates? (It would be a big move which
may rattle the global markets completely and jolt them out of their complacency, if
and when it happens.)
2. Whether rising US yields and sloshing liquidity point to a return of inflationary pressures
in the US or is it premature to talk about inflation when experts are projecting GDP
growth contraction?
3. Whether US stock markets are ignoring the ‘green shoots’ of inflationary concerns while
US bond markets seem to be reading the signals correctly?
4. Whether oil prices will continue to move up despite the predictions of a massive
economic contraction in the developed world and sharp dip in world trade?
5. Whether falling dollar would push up oil prices further?
6. What are the implications of a rising US bond yields on the world economy?
7. Whether Asian economies continue to invest their exports surpluses in the US bonds or
will they diversify their forex reserves into other currencies or commodities? (China
recently has shored up its gold reserves by 450 tonnes, up 75 per cent since 2003)
8. Whether US dollar will be replaced by another reserve currency as is being demanded by
China and other nations?
Note: If you have any thoughts on the above, please let me know

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