US bond action has negative impact for rupee-dollar rate

The US treasury market is a slumbering giant, but once it begins to move there is an extremely strong impact on all financial assets such as equities, commodities and currencies. Over the past few days, 10-year and 30-year treasuries fell strongly, signalling investors to be cautious.

The 30-year US treasury bond futures contract has fallen by nearly 7 percent from its high in September 2011 and over the past five days the fall was a little more than 4 percent. The 10-year bond, on the other hand, has fallen more than 3 percent from its peak in January 2012, but dropped by about 2.25 percent in the past five days. A fall may not seem big when viewed from the prism of equity trading, but in the bond markets the fall is huge.

It is also important to note that both the treasuries have now reached a support zone and could see a bounce. Prices often rise from support levels (Click here for the charts of 30-year treasuries and 10-year treasuries ). Notice that both the treasuries are near a zone marked by white horizontal lines. They are also in the vicinity of the 200-day moving average, which is usually a very strong support level. A moving average level is the average closing price of an asset over a specified period of time.

Potential scenarios: One of the most immediate impacts of the fall in bond prices is the rise in the US dollar, which in turn will push down the Indian rupee and other major currencies. Interest rates move inversely to bond prices. Hence, as bond prices fell, interest rates rose, which gives a higher return on the US dollar. The result is the recent rally in the greenback.

Given the quantitative easing by the US Federal Reserve Bank, the greenback has been earning negative interest rates - i.e. rates below the inflation rate. Now with the fall in treasury prices the market is anticipating positive rates, due to which one sees the greenback rallying again.

A continued positive return on the US dollar could mean a depreciating rupee. This scenario could play out over the long term. However, it’s very possible that the Federal Reserve might have another round of quantitative easing, which could push up bond, equity and commodity prices across the globe.

The initial fall in bond prices is usually the result of investors moving to more riskier assets such as equities and commodities. But as interest rates rise, prices again move back into bonds, leading to a lack of liquidity in equity and commodity markets. Also companies find it prohibitive to borrow and finance economic activity, due to which the economy slows down and equity prices fall.

Remember that US interest rates are a benchmark for global interest rates and the American economy is the engine of global growth. Hence a rise in US rates will result in global interest rates climbing. Even if central banks cut local interest rates, countries will see a flight of capital to the US dollar, pushing up interest rates across the globe. This could lead to a slowdown in an already fragile global economy.

These scenarios could take time to play out. However, in the short term one could see a bounce in treasury markets from their support levels. If the rally in treasuries is driven by risk aversion, one can see equities sell off. However, if the rally is a result of a further easing by the Federal Reserve, all global financial assets will see a rally, except for the US dollar.

But one cannot get out of the global economic problem through serial monetary easing. It did not help Japan and in a consumption-driven economy like the US inflation cannot be far off.

George Albert is Editor, www.capturetrends.com