Interest rates share a close and inverse relationship with bond prices, that further shares an inverse relationship with bond yields. Do you know why bondholders fear a rise in interest rates? Generally, all bonds carry an interest rate risk as fluctuations in the interest rates can affect the bond investors? willingness to pay for the bonds.
Understanding Interest Rates and Bond Prices
Consider a Treasury bond worth $1000 with a maturity period of three years and a coupon rate of 3 per cent. This means that the bond pays 3 per cent a year, i.e. $30, and after three years, one will get the $1000 investment. Let us assume that the market interest rates, and the coupon rate is the same at 3 per cent at the time investor bought the bond.
Suppose after a year of purchase, the market interest rates rose to 4 per cent while the coupon rate remains at 3 per cent. Now, the new bonds become more attractive to the investors as they will pay a higher return than the existing bond. The investor holding the $1000 bond will not be able to sell it easily as it will offer less return, resulting in a drop in the price of the bond. The investor will have to lower the price of the bond in order to make it equivalent to the newly issued bonds offering 4 per cent coupon rate. As the price of the bond falls, the yield to maturity rises. The YTM or the Yield to maturity is the likely return from a bond if it is held till its maturity date.
Conversely, if the market interest rate falls, the existing bonds become more valuable, resulting in a rise in the bond prices and fall in bond yields.
Interest Rate Drops in the US and Australia
In Australia, the interest rates have fallen to its historic low level of 1 per cent after the Reserve Bank of Australia (RBA) slashed it by 25 basis points each in June and July this year. The move was taken by the RBA to support employment growth and help inflation reach the target.
As per the Australian Bureau of Statistics (ABS), the unemployment rate in Australia was recorded at 5.2 per cent in June 2019, which was higher than the expectations of market experts. However, the headline consumer price index (CPI) surpassed expectations during 2019 June quarter, rising by 0.6 per cent. This shows that the Australian economy has started showing some signs of recovery. The recently released retail turnover figures by the ABS also supports this view. The Australian retail turnover has increased in June 2019 by 0.4 per cent against a 0.1 per cent rise in May 2019 in seasonally adjusted terms (see table below).
Despite these improvements, the market experts are anticipating another rate cut by the central bank before the end of the current year. Recently, the RBA Governor has also signalled for further rate cuts in Australia to support inflation, if needed.
Economists are anticipating that the recent rate cut by the Federal Reserve will add pressure to the RBA to reduce its interest rates further.
The Federal Reserve has also slashed its interest rates by 25 basis points for the first time since the 2008 Global Financial Crisis. According to the Fed Chairman, Mr Jay Powell, the move was taken to make some adjustments in the economy which does not indicate that the central bank would continue lowering the interest rates.
Bond Yields Hit Record Lows
The reduction in interest rates along with the ongoing trade war concerns have pulled down the bond yields that are dropping across the globe. The intensification of the trade conflict?between the two largest economies of the world has spurred investors? worries, resulting in a fall in bond yields. The US President?s recent announcement to impose 10 per cent tariff on the remaining $300 billion worth of Chinese goods is providing hints that this trade dispute is not going to end soon.
Retaliating against Mr Trump?s threat, China has allowed its currency Yuan to drop to an 11-year low level. By permitting its level of currency to drop, China has made its exports cheaper. This has raised concerns that China will weaponize its currency in the trade war. Investors are rushing towards safer assets across the globe amid renewed concerns about an economic downturn.
The escalating trade tensions have plummeted the bond yields globally as follows:
Australia: The 10-year government bond rates in Australia have dropped below 1 per cent for the first time in the history as traders are rushing to grab safer assets. The 10-year rate dropped to 0.993 per cent on Tuesday early morning from 1.085 per cent. This rate was below the level of current interest rates in Australia.
The United States: The 10-year U.S. Treasury yields touched 1.68 per cent on Monday, which was the lowest level witnessed since November 2016. The two-year Treasury yield also dropped to 1.571 per cent, representing its lowest rate since November 2017.
Germany: The benchmark yield in Germany declined to its all-time low level on Monday to - 0.52 per cent. The market experts are anticipating that the German bond yield curve might slip into the negative territory if the trade tensions continue to escalate.
Ireland: With investors flocking to invest into government bonds, Ireland?s 10-year bond yield fell below 0 per cent for the first time on Monday. The yield on 10-year Irish bonds that touched 14 per cent level in 2011, started the year 2019 at 1 per cent, falling to -0.001 per cent on Monday. Besides Irish government bond yields, Dutch 30-year government bond yields also declined to -0.053 per cent, taking the yield curve into the negative territory.
The United Kingdom: The UK bond yields hit their record low levels on Monday with 10-year government bond yields dropping to below 0.5 per cent. British 30-year yields also dropped to 1.186 per cent, equivalent to the level observed in August 2016.
The global market sell-off has resulted in a dip in Australian share market with S&P/ASX 200 Index trading 2.3 per cent or 148.2 points down at 6492.1 points (as at 3:00 PM AEST on 6th August 2019). The All Ordinaries index is also trading lower at 6558.3 points with a fall of 2.3 per cent or 152.3 points.?
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