US 10-year bond yields touch 5%: What got it here, what lies ahead

Let’s review and answer these questions one by one.

The US economy has faced very high uncertainty since the Global Financial Crisis in 2008. The US financial markets were the epicentre of the crisis which soon spread to the global shores in quick time. The Federal Reserve cut its policy interest rate – Federal Funds Rate (FFR) - sharply to near zero percent levels. The Federal Reserve started to increase policy rates from 2016 onwards but had to again lower the rates to near zero levels during the pandemic. Post the Russia-Ukraine war, inflation increased significantly pushing the central bank to increase policy rates sharply in the last one year.

Modern monetary policy works on the principle of monetary transmission. Monetary transmission implies that changes in policy rates are transmitted to other interest rates in financial markets: bonds, deposits and loans. The US 10-year bond yield also tracked the FFR. The 10-year yield declined from 5 percent levels in 2007-08 to a range of 2 to 3 percent in the 2009-19 period. The yield declined to less than 1 percent level during pandemic tracking the decline in FFR. Once the FFR rises post the war, the 10 year yield rises sharply back to levels last seen in 2007-08.

Impact Of US Policy Rates

The answer to the first question is that the rise in policy rates have led to a rise in 10-year yields. US inflation has come down from the highs in 2022 but is still higher than the target inflation of 2 percent. This has led markets to expect that the Federal Reserve will tighten the policy FFR even further to bring inflation back to 2 percent. Federal Reserve chair Jerome Powell in a recent speech stressed that the central bank is committed to “bringing inflation down sustainably to 2 percent”. These remarks have only confirmed the market expectations of further policy rate hikes which has translated to 10-year yields touching 5 percent levels.

Apart from monetary policy, the yields have also gone up tracking high budget deficits and debt levels of the US economy. Since 2008, the US economy has constantly run high budget deficits averaging 6 percent of GDP. The persistent high deficits have pushed US Total Debt as a percentage of GDP to double from 60 percent to 120 percent in 2022. The markets were wary of rising US debt even earlier, but due to low interest rates their concerns were brushed aside. With policy interest rates rising, the high public debt is also weighing on high yields.

The answer to the second question is that rise in the US yields leads to capital outflows to US markets. The US bond markets are considered as one of the safest financial assets. With rise in interest rates in the US, it leads global investors to allocate more funds towards the US economy. The capital outflows from other countries leads to decline in equity markets and depreciation in currency. The impact of rising US interest rates was seen in 2022 as well when the currencies depreciated against the US dollar leading to meltdown in UK and European markets. The central bank of Indonesia was forced to increase its policy rates to prevent these outflows.

2021-2030 A Lost Decade?

What do the two answers mean for the third question? It means that the fog of uncertainty continues to widen and thicken for the Indian economy. With each passing quarter the world economy is facing one shock after the other. The year 2023 started with failure of large regional banks in the US and a major commercial bank in Europe. This was followed by the Chinese economy undergoing a crisis. The Russia-Ukraine war continues and we now have a new war between Israel and Gaza which has led to a rise in oil prices.

In October, the IMF released its bi-annual world economic outlook. The IMF noted that the world economic growth is expected to slow from 3.5 percent in 2022 to 3.0 percent in 2023 and 2.9 percent in 2024. The growth numbers are well below the historical (2000–19) average of 3.8 percent.

The World Bank in an earlier report had mentioned that the decade 2021-30 is likely to be a lost decade for the world economy. The share of countries with slower growth than in the previous decade has increased to 73 percent in 2010-21 from 44 percent in 2000-10.  It is highly likely that global growth would have slowed down in the earlier decade of 2010-19 itself. However, the growth was propped up by the ultra-easy monetary and fiscal policies. As the days of easy monetary policy is over, it is creating a lot of tensions in the economy and financial markets. The US banking crisis in the first half of 2023 was also because of the unwinding of easy monetary policy.

The incoming domestic macroeconomic data points to a relatively stable domestic economy. However, the slowing global growth and high uncertainty in financial markets will weigh on India’s economic outlook.  The rising oil prices and higher capital outflows will pose problems in managing inflation and current account deficits.

The stock markets will also remain volatile tracking the global developments.  The Indian economy is the fastest growing economy in the world but it needs support of global growth to achieve the pre-crisis growth levels of 8 percent and above. India’s macroeconomic managers will have to be ever watchful of the emerging new risks from the global economy.

Amol Agrawal teaches at Ahmedabad University, and is the author of 'History of Private Banking in South Canara district (1906-69)’. Views are personal, and do not represent the stand of this publication.