There has been a lot of buzz about surging bond yields lately, especially with Fed head Powell gearing up for his big speech in Congress this week.
What do Treasury yields have to do with the U.S. dollar, interest rates, and the forex market? Here’s what you should know.
First, let’s define bonds, Treasuries, and yields.
Just a quick refresher from the School of Pipsology!
A bond is an “IOU” issued by an entity, such as a company or the government, when it needs to borrow money.
In particular, a Treasury bond is issued by the U.S. Treasury Department when it needs funds to finance its operations.
In return, the borrower promises not only to pay the principal back at a predetermined date but also pay periodic interest or coupon payments.
Bond yields refer to the rate of return or interest paid to the bondholder a.k.a. the person or entity that loaned funds to the borrower.
So why do bond yields matter?
Rising bond yields are USUALLY a sign of a strong economy.
Since bond yields usually rise while investors are selling safe-haven assets like bonds and loading up on riskier assets like equities, these serve as an excellent indicator of a nation’s stock market performance.
A stronger stock market then tends to increase demand for the nation’s currency.
On the flip side, if the economy is in bad shape, then investors won’t be too eager to load up on risky assets and prefer to load up on safer assets instead.
Since government bonds are super safe (given that they’re guaranteed by the government that can just print money to pay off their debts), investors usually buy up bonds during risk-off times, causing bond yields to fall.
TL;DR: Rising bond yields are usually bullish for a currency while falling bond yields are typically bearish.
How are Treasury yields connected to Fed rate expectations?
Treasury bond yields can also serve as a good indicator of interest rate speculations. Since Treasuries are basically U.S. government bonds, higher interest rates from the Fed (or expectations of such) will also push Treasury yields higher.
After all, central banks lean towards tightening monetary policy when the economy is performing well or to keep inflation in check.
Now this is what makes Fed head Powell’s upcoming speech particularly interesting: The U.S. economy isn’t exactly in its best shape while higher pressures are a concern because of free-flowing stimulus, yet Treasury yields have been surging.
What’s a central bank head to do?!
Market watchers are expecting Powell to get asked about his take on this disconnect between yields, growth, and inflation and whether or not they’re likely to use any of the Fed’s policy tools soon.
Hinting that the FOMC could tighten monetary policy faster than the market expect could mean a sharp boost for the Greenback, but this might rattle investors and companies able to benefit from current low interest rates.
Instead, Powell is widely expected to assure that policymakers are comfortable with the economy’s growth and inflation prospects, which might be enough to calm the markets but likely lead to a dip for the dollar.
