US Bonds Yields to Deflate values

5 October 2018

According to the US Federal Reserve, the U.S. GDP growth will rise to 3.1 percent in 2018, 2.5 percent in 2019, and 2.0 percent in 2020. Over this period the core inflation rate will rise from 2.0 percent in 2018, to just 2.1 percent in 2019 and 2020, which will provide the Fed some room to move interest rates if the US dollar surges in the mean time. Currently US rates are expected to increase to 2.5 percent in December 2018, 3.0 percent in 2019, and 3.5 percent in 2020. Treasury yields are however expected to increase as the demand for the US dollar increases. Yields on 10-year US Treasuries surged to a seven-year high of 3.22 per cent this week after the Federal Chairman said the US economy was firing on all cylinders and issued fire-breathing comments on interest rates. FITCH Ratings took hold of this comment and warned that global bond markets face a rude shock if the US Federal Reserve jams on the brakes to avert overheating, with grave implications for inflated asset prices across the world. The chart below shows the current US and Australian 10 yr Bond Yields and the gradual increase in the US yield since Q3 2017. In fact US bond yields are rising fast across the entire “yield curve” of all maturities, implying that that the market has suddenly realised that the global demand for US dollars is shrinking as global markets reduce their QE programs and that as a result US Bond yields will naturally increase. Thus, the cost of money is now forecast to increase quicker than most expect posing a threat to high-debt companies that have been shielded by QE. The implications are significant for US equity markets which have risen to new highs in recent times, increasing the prospect of a correction to more normal pricing fundamentals. By contrast to the US, Australian bond yields have been relatively stable, sitting between 2.5% and 3.0% for the past 2 years, even as the US rates have exceeded 3.1% for the first time since mid 2011. However, with the Australian Dollar now dropping to 70c (down 9% this year), there is some concern that the Reserve Bank may need to move to increase rates to avoid a quick drop into the mid 60’s, which will drive inflation well ahead of current forecasts. For Property markets in Australia, the current spread to 10 year bond rates is within the normal range for the Commercial, Industrial and Retail sectors, however if bond yields rise in Australia to counteract the rise in the US yields, the implications are that property yields will also need to rise to maintain a similar risk adjusted position. In the short term, total returns for property are unlikely to be impacted as rental increases are often linked to inflation, however capital re-allocation both locally and global is likely to change the weight of capital and highly leveraged assets will face greater challenges.