FRIDAY, March 29, 2024
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Brewing up a perfect storm for a rate rise

Brewing up a perfect storm for a rate rise

LAST YEAR I wrote several articles to warn investors that the shift in monetary policy stances at the world major central banks would cause turbulence in financial markets.

To quote myself: “accommodative monetary policies are designed primarily to suppress long-term interest rates, hence keep borrowing cost down and encourage financial risk taking. Riskier asset such as equities, speculative grade high-yield bonds and emerging market bonds have been prime beneficiaries as they provide higher return alternatives to the depressed government bond yields. 
Therefore, the most probable impact of reversing these policies would be the rise in long-term bond yields, which will in turn exert downward pressure those risky asset prices."
Now here we are, the US 10-year Treasury yield rose to 2.8 per cent from 2.0 per cent in September triggering major stock markets to sell-off by about 10 per cent across the globe. Going forward, several factors will likely keep pushing bond yields higher. 
In terms of supply, the US bond issuance will have to rise sharply in order to offset lower government revenue from tax cut. US Treasury Department estimated that it will borrow $955 billion in fiscal year 2018, an 84 per cent increase over the $519 billion they borrowed in 2017. 
Rising bond issuance generally means that US government will have to pay higher interest rates to entice more bond buyers.
On the demand side, bond purchase by the central banks is set to decline in 2018 as Fed started balance sheet run off, while ECB and BoJ wind down QE. Net asset purchases from the three central banks will grind to halt in the fourth quarter of this year.
Falling demand from central banks means that private investor will have to step up purchase to absorb rising bond supplies. They will likely do so at higher interest rates especially if inflation rises more than expected. In 2017, core inflation in the US ended a year lower due to various idiosyncratic factors such as the price cut in wireless telephone packages. 
But effects of these temporary factors are about to fade and early signs of inflation recovery are emerging. The implementation of tax cut and other fiscal stimulus in the US will also add inflationary pressure in 2018.
All in all, I believe US 10-year treasury yield will rise further to 3 per cent due to the combination of market forces mentioned above. This will continue to put pressure on the stock market as rising bond yields forces compression on P/E multiples. 
However, we do not expect stock market to fall into bear market territory as strong economic growth keeps earnings on the upward trend.

KOMSORN PRAKOBPHOL is head of strategy at TISCO Economic Strategy Unit. He can be reached via www.tiscowealth.com or|[email protected].
 

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