May 2 (NBD) -- The yield on the benchmark 10-year Treasury note surpassed the key psychological level of 3 percent on April 24 for the first time since January 2014. With yields on the apparent rise, market participants were wondering what this would mean for the future of asset markets, and more importantly, the global economy.

With regard to this, NBD had exclusive interviews with Paul Donovan, chief economist of UBS Global Wealth Management and Omer Esiner, chief market analyst of Commonwealth Foreign Exchange, who shared their interpretation of  10-year Treasury yield hitting 3 percent, analyzed its impact on the market and gave valuable risk-preventing suggestions to investors. 

Strong economic data, principal cause of rise in 10-year U.S. Treasury yields

NBD: Plans of U.S. debt issuance and rising crude oil price are important reasons for the continued rise in 10-year U.S. Treasury yields, media reports said. And we also noted that the 10-year Treasury yields have risen nearly 25 percent since the beginning of this year. From your viewpoint, what are the main factors driving the continuous rise of 10-year Treasury yields? Will these factors continue to push up the 10-year Treasury yields?

Donovan: U.S. government bond yields remain at very low levels, given the economic position of the United States. The amount of debt owned by the Federal Reserve (Fed), and by foreign central banks, continues to distort the market. This is likely to keep yields lower than would otherwise be the case. However, the Fed has continued to signal a willingness to raise interest rates this year. Underlying economic data remains relatively strong. The labor market is pushing up wages, and this will gradually feed into inflation. And finally, the fiscal deficit of the U.S. is larger than initially expected (as attempts to close tax loopholes have not been as successful as hoped, and tax revenues are therefore likely to disappoint). The oil price is less important in my view. Most central banks will ignore the impact of oil on headline inflation. Unless wages rise in response to higher oil prices, it is unlikely to be a major problem.

I think markets are moving to price in most of these factors and it is unlikely that we will have significant further increases in the bond yield. A modest increase is possible, especially if the budget deficit data is worse than expected, but a large move will be limited by the Fed / foreign central bank holdings of debt.

Esiner: The factors driving the yields higher have been the improving performance of the U.S. economy. We've seen strong sales number, strong production number, strong consumer confidence and new home sales. The overall CPI level has been creeping higher. We've seen anecdotal evidence of rising price pressures. Some corporate earnings reports showed that some companies were finding price pressures with respect to input cost and resource prices. So there are signs of rising inflation in most of the data anecdotally. I think the overall U.S. economic data has been one of the key drivers for rise in yields.

We've also seen an improving geopolitical backdrop over the last two weeks. The U.S Treasury Secretary is travelling to China to talk about trade issues between the U.S. and China. That was well received by the market as a progress and eventually limiting the risk of protectionism or trade war between the two countries. That was a very good sign that I think was pushing the yields higher. And also I think, the leader of North Korea is coming to negotiating table with South Korea, and eventually with the U.S. That was seen as a welcomed improvement in the geopolitical backdrop. All those factors combined pushed the yields higher. 

Photo/Shetuwang

NBD: The 10-year Treasury yield is seen as an indicator of global borrowing costs. With the yields climbing, corporate borrowing costs are set to rise, and the good days of borrowing cheap in recent years have ended, so do state and local government borrowing costs. How would this trend affect U.S. public infrastructure investment, mortgage rates and student loans?

Donovan: Treasury yields are less influential than they were. It is worth remembering that most of the US corporate sector has no access to the bond market. Small and Medium sized Enterprises (SMEs) are around 60 percent of private sector GDP. Their borrowing is from banks. Bank interest rates are responding more to competitive pressures than to movements in the bond markets, and SME borrowing costs are likely to be largely unaffected by these moves. Mortgage rates are more closely tied to bond rates, but of course it is only NEW mortgages that are affected. Existing mortgage holders will have fixed rates, and their borrowing costs and disposable income will be unaffected.

We should also remember that we are talking about a relatively small change in yields so far. This is not an economically important move. 

Esiner: It's true that the U.S. mortgages tend to be tied, for the most part, to the 10-year yields. In other words, the rate at which you are borrowing for the housing which tends to be 30-year fixed-rate mortgages is closely tied to the 10-year yields. So as yields move higher, it does make the cost of borrowing incrementally higher for mortgages and for new home buyers. This is definitely a factor to keep an eye on, but it's one of many factors.

Historically, we're still working at very low borrowing cost. It may not feel like that to certain buyers who've become accustomed to rates below 4 percent on a 10-year mortgage. By historical standards, that's very low. Many studies have shown that the biggest single driver of housing market activity in the U.S. tends to be the unemployment rate. So I think the rising rates are one of many factors in the overall housing market, and I think, more broadly, the overall level of employment in the U.S. is probably the biggest single driver of the housing market.

The borrowing costs are likely to keep pressure on overall yields, and rising yields brought rising interest rates, but the Fed could potentially put the brakes on the housing market recovery in the U.S. If you have a situation where overall economic activity in the U.S. remains very strong and you have a situation where the unemployment rate is bouncing against that 4 percent level, those are historically very strong levels of employment. I think the impact of rising rates that happen gradually and that happen in orderly way, may be less of a major influence on the housing market than the overall performance of the economy. 

Photo/Shetuwang

Diversify asset portfolio to lower risks

NBD: The rise in 10-year Treasury yields has long been seen by many investors as one of the top risks for the U.S. stock market this year, and 3 percent is another important psychological point. U.S. stocks fell sharply after the 10-year Treasury yield topped 3 percent on Tuesday. JP Morgan also expects 10-year Treasury yields to rise to 3.15 percent by the end of 2018, the same as the median forecast of 56 analysts surveyed by Bloomberg. If the 10-year Treasury yield continues to rise, what signal would it bring to the U.S. stock market?

Donovan: I do not believe that 3 percent is an important yield level. It has no economic significance. If the yield is rising because prices are rising, because companies are raising prices, that would be a signal that company earnings growth will be stronger than previously thought. If the yield is rising because economic data is stronger and investors are moving out of bonds and into equities, it is good for the equity market. If the yield is rising because the Fed is trying to reduce inflation with an aggressive tightening of policy, it is bad for the equity market.

NBD: Prominent investors including Jeffrey Gundlach of DoubleLine Capital and Scott Minerd of Guggenheim Partners, see 3 percent as an indicator of whether the 30-year bull market is over. In the minds of market analysts, the market could drop from heaven to hell, once the yield is above 3.05 per cent, reaching levels in 2011. In your viewpoint, how should investors avoid risks?

Donovan: I think that a dramatic sell off in government bonds is very unlikely. The idea that a bond yielding 3.05 percent is significantly more likely to trigger a mass sell-off than a bond yielding 2.98 percent is not very credible. But the way to avoid risks of a more significant bond sell-off is to hold a diverse portfolio of assets (as it always is). Diversification does not mean owning zero bonds-investors should have bonds as a hedge against trade war risks, economic recession risks etc. But diversification means owning a range of assets that will preserve capital under a range of economic scenarios.

NBD: Also last Tuesday, 2-year Treasury yields rose 1 base point to 2.49 percent, the highest level since the 2008 financial crisis. Some say that although the 3 percent 10-year Treasury yields got more attention, short-term Treasury yields (e.g. one-year, two-year yields) change may exert greater influence on the market. What do you make of this opinion?

Donovan: Short-term yields respond mainly to the Fed Funds rate. Long term yields react to financial regulation, quantitative policy, and supply. So the importance of short end yields or long end yields depends on whether investors are focused on the policy of the Fed or on other factors. Thus, another way of saying that the 2 year Treasury is at the highest yield since the financial crisis is to say that Fed Funds (and expectations of Fed Funds) are at the highest level since the financial crisis.

Esiner: It's true that the shorter-term borrowing costs are more impactful on many business operations. It's also true that the Fed has more control over the shorter end of the curve, and that is probably more accurate reflection of where the market monetary policy is going in the near term. Whether or not it's more influential is a question of debate. There's a lot of borrowings that are tied to the 10-year rate. So whether we are looking at are business and commercial loan rates, whether we are looking at whole mortgage rate or the credit card rate in the U.S., and a lot of these are tied to the 10-year rate. That's why it's generally seen as the benchmark of overall borrowing.

Email: gaohan@nbd.com.cn; zhanglingxiao@nbd.com.cn