Fed may be reducing easy money, but here’s why Sensex will keep soaring

yellen_janet_040512_8x10Vivek Kaul

In theory there is no difference between theory and practice. In practice there is.

Yogi Berra

A question I am often asked is why are the stock markets around the world still rallying despite the Federal Reserve of United States going slow on printing money. In a statement released yesterday the Fed decided to cut down further on money printing.
It will now print $15 billion per month instead of the earlier $25 billion. This was the seventh consecutive cut of $10 billion. Since December 2012, the Federal Reserve had been printing $85 billion per month. This money was pumped into the financial system by buying mortgage backed securities and government bonds. The idea was that by increasing the amount of money in the financial system, long term interest rates could be driven lower. The hope was that at lower interest rates, people would borrow and spend more.
From January 2014, the Federal Reserve decided to buy bonds worth $75 billion a month, instead of the earlier $85 billion. This meant that the Fed would be printing $75 billion a month instead of the earlier $85 billion. This cut in money printing came to be referred to as “tapering”, which means getting progressively smaller. Since then the amount of money being printed by the Federal Reserve has been tapered to $15 billion per month. At this pace the Federal Reserve should be done at dusted with its money printing by next month i.e. October 2014.
A lot of this printed money instead of being lent out to consumers has found its way around into stock markets and other financial markets around the world. The Dow Jones Industrial Average, America’s premier stock market index, has rallied more than 30% since October, 2012. This when the American economy hasn’t been in the best of shape.
The FTSE 100, the premier stock market index in the United Kindgom, has given a return of 15% during the same period. The Nikkei 225, the premier stock market index of Japan has rallied by 53% during the same period. Closer to home, the BSE Sensex has rallied by around 43% during the same period.
Stock markets around the world have given fabulous returns, despite the global economy being down in the dumps. The era of easy money unleashed by the Federal Reserve has obviously helped.
Nevertheless, the question is with the Fed clearly signalling that the easy money era is now coming to an end, why are stock markets still holding strong? One reason is the fact that even though the Fed might be winding down its money market operations, other central banks are still continuing with it.
The Bank of Japan, the Japanese central bank is printing around ¥5-trillion per month and is expected to do so till March 2015. The European Central Bank is also preparing to print €500-billion to €1-trillion over the next few years. What this means is that interest rates in large parts of the Western world will continue to remain low. Hence, big institutional investors can borrow from these financial markets and invest the money in stock markets around the world.
The second and more important reason is that the Federal Reserve does not plan to shrink its balance sheet any time soon. Before the financial crisis started in September 2008, the size of the Federal Reserve balance sheet stood at $925.7 billion. Since then it has ballooned and as on August 27, 2014, it stood at $4.42 trillion.
The size of the Fed balance sheet has exploded by close to 378% over the last six years. This has happened primarily because the Fed has printed money and pumped it into the financial system by buying bonds, in the hope of keeping interest rates low and getting people to borrow and spend.
Janet Yellen, the current Chairperson of the Federal Reserve made it very clear yesterday that the Fed was in no hurry to withdraw this money from the financial system. It could take to the “end of the decade” to shrink the Fed’s huge balance sheet
“to the lowest levels consistent with the efficient and effective implementation of policy.”
What this essentially means is that the money that the Fed has printed and pumped into the financial system by buying bonds, will not be suddenly withdrawn from the financial system. When a bond matures, the institution which has issued the bond, repays the money invested to the institution that has invested in it.
If the investor happens to be the Federal Reserve, the maturing proceeds are paid to it. This leads to the amount of money in the financial system going down, and could lead to interest rates going up, as money becomes dearer.
This is something that the Fed does not want, in order to ensure that individuals continue borrow and spend money, and this, in turn, leads to economic growth. Hence, the Fed will use the money that comes back to on maturity, to buy more bonds and in that way ensure that total amount of money floating in the financial system does not go down.
This means that long term interest rates will continue to remain low. Hence, investors can continue to borrow money at low interest rates and invest that money in different parts of the world.
Yellen also clarified that short-term interest rates are also not going to go up any time soon. As she said “economic conditions may for some time warrant keeping the target federal funds rate below levels the committee views as normal in the longer run.”
The federal funds rate is the interest rate that banks charge each other to borrow funds overnight, in order to maintain their reserve requirement at the Federal Reserve. This interest rate acts as a benchmark for short-term loans.
Given these reasons, the stock markets around the world will continue to rally, at least in the near term, as the era of easy money will continue. These rallies will happen, despite global growth being down in the dumps and the fact that the global economy is still to recover from the financial crisis that started just about six years and three days back, when the investment bank Lehman Brothers went bust on September 15, 2008.
To conclude, Ben Hunt who writes the Epsilon Theory newsletter put it best in a recent newsletter dated September 8, 2014, and titled
The Ministry of Markets: “No one doubts the omnipotence of central banks. No one doubts that market outcomes are fully determined by central bank policy. No one doubts that central banks are large and in charge. No one doubts that central banks can and will inflate financial asset prices. And everyone hates it.”
The article appeared originally on www.FirstBiz.com on Sep 18, 2014

 (Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

Sensex reclaims 21k: Why yen carry trade will ensure ‘easy money’ continues

1000-yen-natsume-sosekiVivek Kaul
The Federal Reserve of United States, the American central bank, plans to go slow on money printing starting this month i.e. January 2014. Until the last month the Federal Reserve printed $85 billion every month. It pumped this money into the financial system by buying government bonds and mortgage backed securities.
The idea was to ensure that there is enough money going around in the financial system and, thus, help keep long term interest rates low. This would hopefully encourage people to borrow and spend and, thus, help the American economy to start growing again.
The risk was that all the money being printed would lead to inflation. While the money printing hasn’t led to consumer price inflation, it has led to a rapid rise in the stock market as well as real estate prices in the United States. This is primarily because people (which includes investors) could borrow at very low interest rates and invest that money in stocks as well as buy homes.
“Since the turnaround began on March 9th, 2009, the S&P-500 index has chalked up gains of +175%, – ranking it as the fourth longest bull market of all-time. In cash terms, the US-stock market has generated $13.5-trillion in paper wealth,”
writes Gary Dorsch, Editor, Global Money Trends, in his recent column.
The 20 City S&P/ Case- Shiller Home Price Index, the leading measure of U.S. home prices,
rose by 13.6% in October 2013, in comparison to a year earlier. This is the highest gain in prices since February 2006, when prices had risen by 13.9% in comparison to the year earlier. Real estate prices in the United States, as measured by the 20 City S&P/Case- Shiller Home Price Index had peaked in April 2006.
So the markets in the United States as well as other parts of the world have done very well over the last few years as the Federal Reserve of United States has printed truck loads of money. The interesting thing is that even with the Federal Reserve deciding to go slow on money printing, the markets haven’t fallen.
It is worth pointing out here that when the Federal Reserve Chairman Ben Bernanke had first talked about going slow on money printing (or tapering as he called it) in May-June 2013, financial markets (stock, bond and foreign exchange) had reacted very badly to the news.
But when the Federal Reserve has actually gone ahead with “tapering” and decided to print $75 billion per month (instead of the earlier $85 billion) the markets haven’t reacted violently at all. Why is that the case?
One reason is the fact that the Federal Reserve has managed to communicate to the investors that tapering isn’t really tightening. What that means is that even though the Federal Reserve will go slow on money printing and not print as many dollars as it was in the past, it will ensure that short term interest rates will continue to remain low.
As Jon Hilsenrath writes in the Wall Street Journal “Most notably, the Fed’s message is sinking in that a wind down of the program won’t mean it’s in a hurry to raise short-term interest rates.”
This means at some level the dollar carry trade can continue. Hence, big institutional investors can continue to borrow in dollars at low interest rates and invest that money in different financial markets all over the world.
It needs to be pointed out that whether the Federal Reserve decides to further cut down on money printing depends on the overall state of the American economy. One particular number that the Federal Reserve likes to look at is the number of jobs created every month. In December 2013, the US economy saw a net increase of 74,000 jobs.
As Andre Damon writes onwww.globalresearch.ca “The US economy generated a net increase of only 74,000 jobs in December, about one third the number predicted by economists and less than half the amount needed to keep pace with population growth. The increase in non-farm payrolls was the lowest since January 1, 2011, when the economy added 69,000 jobs. Friday’s number followed two months in which payrolls grew by 200,000 or more, leading to claims that the economy was shifting into high gear.” This implies that it will be difficult for the Federal Reserve to cut down from the $75 billion that it is currently printing in a month. Hence, it is unlikely that the Federal Reserve will stop money printing any time soon.
What has further energised the financial markets is the fact that the Bank of Japan, the Japanese central bank, is also printing money big time. As Dorsch writes “The Bank of Japan(BoJ) has taken a page out of the Fed’s quantitative easing playbook, – but multiplied by 3-times. The BoJ is buying ¥7.5-trillion of government bonds (JGB’s) per month, and intervening directly in the equity market, by purchasing ¥1 trillion of exchange-traded funds linked to the Nikkei-225 each year. The BoJ aims to inject $1.4-trillion into the Tokyo money markets by April ‘15, equal to a third of the size of Japan’s $5-trillion economy.”
The Federal Reserve until last month was printing $85 billion every month. This works out to a around $1.02 trillion every year. The amount of money being printed by the Bank of Japan is more than that. What this means is that interest rates in Japan will remain low. This will encourage the yen carry trade, where an investor can borrow in yen and invest the money in different financial markets around the world.
What will also help is the fact as the Japanese central bank keeps printing money, the yen will depreciate against the dollar and thus spruce up returns. In the last one year the yen has gone from around 89 to a dollar to almost 103-104 to the dollar currently. “With liquidity injections of ¥7-trillion per month, Tokyo has engineered the yen’s -18% devaluation against the US$, -23% against the Euro, -15% against the Korean won, and a -12% slide against the Chinese yuan,” writes Dorsch.
How does this help yen carry trade? Let us understand this through an example. Let’s say an investor borrows 100 million yen and converts them into dollars. Currently one dollar is worth around 104 yen.
Hence, 100 million yen can be converted into around $961,538 (100 million yen/104). This money is invested in financial markets around the world and let’s say at the end of one year has grown by around 8% and is now worth $1.04 million. One dollar by then let us assume is worth 110 yen.
When $1.04 million is converted into yen, the investor gets 114 million yen. This means a return of 14%. Hence, the depreciating yen adds to the overall return for anyone who borrows in dollars.
It also means that financial markets around the world will see foreign investors continuing to bring in more money. India should also benefit from the same over the next one year. Given this, the BSE Sensex should continue to go up till December 2014. CLSA expects the Sensex to touch 23,500 by December 2014. Deutsche Bank Markets Research expects the Sensex to do even better and touch 24,000 by the end of this year. It does not matter that the real economy will continue to be in doldrums.

The article originally appeared on www.firstpost.com on January 13, 2014
(Vivek Kaul is a writer. He tweets @kaul_vivek)


The Almighty Dollar and the Fallen Rupee


I am not an economist. I am an old bond trader,” said Drew Brick, who leads the Market Strategy desk for RBS in the Asia-Pacific region, when Forbes India caught up with him for breakfast on a recent visit to India. “We trade the noise,” he added emphatically.
Right now, the noise is about what US Fed Chairman Ben Bernanke said or didn’t say about his bond-buying. And this is why one needed to know what the “old bond trader” had to say about why the rupee was falling against the dollar. “What is happening now is really not a function of anything really specific to India, although India has an inclination to have problems,” explained Brick. Finance Minister P Chidambaram should welcome at least the first part of his statement, since he has been defending the “fundamentals” of the economy to anybody who would listen.
The foreign exchange market hasn’t been one of them, for it has been cocking a more attentive ear to what Bernanke had to say. And on June 19, he said that the Fed would go slow on its money printing operations in the days to come as the US economy started reviving. “If the incoming data are broadly consistent with this forecast…it would be appropriate to moderate the monthly pace of purchases later this year…And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year,” Bernanke said at a press conference that followed the meeting of the Federal Open Market Committee (FOMC).
That statement impacted the bond markets most—and the carry trade. The carry trade is about investors who borrow in low-yield currencies to invest in assets in other markets, presumably with higher yields. Bernanke’s statement signalled that bond yields may go up, and that meant carry-trades would have to be unwound. Brick confirmed this: “We are seeing the unwinding of a lot of carry trades that have been taking place across the globe in the chase for yield.”
Brick, who bears a striking resemblance to Hollywood actor Richard Gere, had worked with BNP Paribas, Morgan Stanley and legendary bond kings Pimco before he joined RBS last year. He explained why the dollar is holding up even though US growth isn’t exactly something to write home about. “Some people think that the United States is the least dirty shirt in the drawer. And it has got growth, though not a very high trajectory of growth,” said Brick.
It is this minor revival that is creating problems for carry trade investors who have borrowed and invested money across the world on the assumption that US interest rates will rule close to zero in the foreseeable future.
The return of economic growth in the US has pushed up 10-year treasury bond yields. The yield, which stood at 1.63 percent in the beginning of May, has since risen to 2.5-2.6 percent.
Said Brick: “A bond works by a simple method. It measures three fundamental variables. What are they? Everybody who trades bonds thinks about where is growth going? Where is inflation going? And what is the risk premium?”
And what do we get if we apply this formula to calculate the yield on 10-year US treasuries? Explained Brick: “If the 10-year yield today is around 2.2 percent [it was so, on the day the interview was conducted], what would you say the US nominal growth is? Around 2 percent. What do you think inflation is? Around 1 percent. What do you think the risk premium is in the market place? Clearly it’s risen a little, so maybe it is 30 basis points.” (100 basis points make 1 percent).
This gives us a 3.3 percent yield on 10-year US treasuries. “And when the 10-year treasury is trading at a yield of 2.2 percent, what do you do as a trader? You sell that freakin’ thing. And that’s the risk,” said Brick.
When lots of bonds are sold at the same time, the price of the bond falls and thus the yield, or the return, goes up. And that is precisely what has been happening with 10-year US treasuries, with the yield shooting up by nearly 60 basis points from 1.63 percent in early May to nearly 2.2 percent on June 18, 2013. After Bernanke’s press conference on June 19, the yield shot up dramatically. On June 24, it stood at nearly 2.6 percent.
The 10-year US treasury is extremely important,” said Brick. This is because it sets the benchmark for interest rates on all other kinds of loans in the United States, from interest rates charged by banks on home loans and home equity loans to interest at which carry trade investors can borrow money. More important for the rupee’s health, when the 10-year US treasury yield goes up, carry trades become less attractive. “The days of quantitative easing-sponsored carry trading are about to be pared, perhaps significantly. Remember, as volume rises, the cost of carry rises and so, too, does market illiquidity,” said Brick.
This is why investors have been selling a lot of the assets they have invested in and repatriating the money back to the United States. The Indian debt market has been hit by this selling and foreign institutional investors (FIIs) have pulled out nearly $5 billion since late May. In fact, stock markets all over the world also fell in the aftermath of Bernanke announcing that he will go slow with his money printing operations in the days to come.
The Federal Reserve has been printing $85 billion every month. It uses $40 billion to buy mortgage-backed securities, and $45 billion to buy long-term American government bonds. By doing so, it has been pumping money into the financial system and keeping interest rates low in order to spur growth.
But the growth did not come. Said Brick: “The truth is that central banks are running up their monetary bases but they are not necessarily getting any bang for the buck in terms of the turnover of the cash that they are creating into the system.”
Bernanke did not say he was going to withdraw all kinds of quantitative easing, or even that he would start withdrawing the easy money. That would require him to sell all the bonds he bought. The market though is getting ready for that to happen. “The market is already trading this. Forward pricing in the markets is already adjusting for this,” said Brick.
Low interest rates in the US after the 2008 Lehman crisis led Asians to borrow a lot in cheap dollars. “All across Asia, non-financial corporations, and even households to a small extent, have been taking out huge amounts of dollar funding,” said Brick. And this may cause some major problems in the days to come. “Right now we are seeing an unwinding of the dollar carry trade but at some point the dollar is going to turn and then the servicing cost of that debt is going to be all the more tricky. Every crisis that I have ever read through, and I am an old man, has always been born on the back of rising rate cycles that move higher with the dollar in tow. This makes the financing cost of debt in emerging markets more expensive. That’s across the board. That’s probably true here in India as well,” he added.
Brick suspects that there are problems lurking in the woodwork. “Corporates are relatively sanguine with a weaker rupee. But where are the cockroaches in the system? Where has the dollar funding been taken on offshore? Have Indians thought about what it means to have a rupee possibly at 65 to a dollar? And what would that possibly mean for the financing cost of banks that have almost certainly been taking on relatively cheap quantitative easing-sponsored cash in their offshore operations to be able to finance lending?”
If the rupee gets to 65 to a dollar, our oil bill will go for a toss. And will gold have a rally in rupee terms, assuming that its price stays stable in dollar terms? “Gold is a zero interest, infinite maturity, inflation-linked bond. That’s all gold is,” Brick responded. The supposed end of quantitative easing in the United States has taken some sheen off the yellow metal. “But it’s possible that we may have another move higher. The selloff has been rather pronounced. But it’s not the core issue here. Gold is a symptom of the larger issue,” said Brick.
Brick also feels that the bond market in the United States might be getting a little ahead of itself.
He reminded us about March 2012, when the 10-year US treasury yield had moved up to 2.4 percent. “Then, Ben Bernanke showed up on the tapes 10 straight trading days, running it back down [i.e. the yield]. My guess is that something like that will occur this time. The market is way ahead of itself.”
The broader point is that if yields rise at a fast pace, they will push up interest rates on loans. This will slow down some of the economic growth that seems to be returning to the United States. And that situation may not be allowed to play out.
So where does that leave Asia? “If quantitative easing gets tapered off as a consequence of relatively strong growth, then quite frankly Asian equities probably will hold in pretty well,” explained Brick.
And then came the but. “But if treasuries sell off massively as a consequence of technical reasons and a marketplace getting well ahead of itself, and dollar funding and interest rates get higher, then equities will get wasted out.”
What is another scenario? I can give you millions of scenarios. But the truth is we don’t know in the opening stages, the first minutes of a three-hour movie, how it is going to play out. It’s going to be like a Bergman movie. I don’t know how it is going to play out but it is going to be weird at times,” Brick said.
Weird it will be, for “even the end-point of tapering [of Fed bond purchases] leaves the Federal Reserve with a still-gargantuan 25 percent-of-US-GDP balance-sheet. Pressures will sustain, even with reprieves,” Brick concluded.

The interview originally appeared in the Forbes India magazine edition dated July 26, 2013

It's just another manic Monday for the Indian rupee

 rupeeVivek Kaul  
The Indian rupee crashed to an all time low level, crossing 61 to a dollar, this morning. As I write this one dollar is worth around Rs 61.2. On Friday when the foreign exchange market closed one dollar was worth Rs 60.24.
The rupee has crashed in response to return on the 10 year American treasury bond spiking to 2.73% on Friday i.e. July 5, 2013. This was an increase of 21 basis points (one basis point is equal to one hundredth of a percentage) in comparison to the return on Wednesday i.e. July 3, 2013. The bond market was closed on July 4, 2013, the American independence day.
A 10 year treasury bond is a bond issued by the American government to finance its fiscal deficit i.e. the difference between what it earns and what it spends. These bonds can be bought and sold in the open market. This buying and selling impacts the price of these bonds and hence their overall return.
The return on the 10 year American treasury bond spiked in response to better than expected jobs data. American businesses added 1,95,000 jobs in June, 2013, which was better than what the market expected. This faster than expected recovery in the job market is being taken as a signal that the American economy is finally getting back on track.
Since the start of the financial crisis in late 2008, the Federal Reserve of United States, the American central bank, has been printing dollars and pumping them into the financial system. This is to ensure that there are enough dollars going around in the financial system, so that interest rates continue to stay low. At low interest rates people are likely to borrow and spend more. Consumer spending makes up for around 71-72% of the American gross domestic product. Hence, an increase in consumer spending is very important for the American economy to keep growing.
The Federal Reserve prints dollars and pumps them into the financial system by buying bonds worth $85 billion every month. This includes government bonds and mortgage backed securities. On June 19,2013, Ben Bernanke, the Chairman of the Federal Reserve of United States, had said that if the American economy kept improving, the Federal Reserve would go slow on money printing in the time to come. He had said that it was possible that the Fed could stop money printing to buy bonds by the middle of next year.
The jobs data has come out better than expected. This is a signal to the bond market that the Federal Reserve will start going slow on money printing sooner rather than later. Several estimates now suggest that the Federal Reserve will start going slow on money printing as soon as September this year.
As and when the Federal Reserve goes slow on money printing the interest rates are likely to go up, as the financial system will have lesser amount of dollars going around. This is likely to push interest rates up. Bond prices are inversely related to interest rates. So as interest rates will go up, bond prices will fall, leading to losses for investors.
But markets don’t wait for things to happen. They start discounting likely happenings in advance.
Given this, the bond market investors are selling out on American government bonds to limit their losses. This has led to bond prices falling. Even when bond prices fall, the interest paid on these bonds continues to remain the same. This means a higher return for the investors who buy the bonds that are being sold.
So this has pushed the return on the 10 year American treasury bond to 2.73%. On May 1, 2013, the return on the 10 year American treasury bond was 1.66%.
An increase in return on government bonds pushes up interest rates on all other loans. This is because lending to the government is deemed to the safest, and hence the return on other loans has to be greater than that, to compensate for the higher risk involved.
As mentioned above, in the aftermath of the financial crisis, the Federal Reserve started to print money, in order to get the American economy up and running again. The trouble was that the average American was just coming out of a huge borrowing binge and was not ready to borrow again, so soon.
But the financial system was slush with money available at very low interest rates. This led to large institutional investors indulging in what came to be known as the dollar carry trade. Money was borrowed in dollars at low interest rates and invested in financial assets all over the world. The difference in return between what the investor makes and the interest he pays on his dollar borrowing, is referred to as the carry.
With interest rates in the United States going up, as returns on government bonds up, the carry made on the dollar carry trade has been on its way down. The arbitrage that investors were indulging in by borrowing in dollars and investing those dollars all across the world with a prospect of making higher returns is no longer as viable as it used to be.
A lot of this money came into the Indian stock market as well as the bond market. In case of the bond market the amount of return that can made is limited. Hence, carry trade investors who had invested in Indian bonds have been selling out. Between May end and now, foreign investors have sold out around $6 billion worth of Indian bonds.
When they sell out on these bonds, the investors are paid in rupees. In order to repatriate these rupees abroad they need to convert them into dollars. Hence they sell rupees to buy dollars. When they sell rupees there is a surfeit of rupees in the market and not enough dollars going around. In this scenario, the rupee tends to fall in value against the dollar.
And that’s what has happened in the morning today when the rupee crossed 61 to a dollar. As the rupee loses value against the dollar, foreign investors face a higher amount of currency risk, leading to more of them selling out. This puts further pressure on the rupee. ( you can read more about it here).
The pressure on the rupee will continue in the days to come. If American bond yields keep going up, more foreign investors will sell out of India and this will lead to the rupee continuing to lose value against the dollar. Over and above that there are several home grown issues that will ensure that the rupee will keep depreciating against the dollar. (You can read more about it here) This is not the last manic Monday we have seen as far as the rupee is concerned.

 PS: In the time that it took me to write this piece, the rupee recovered against the dollar. One dollar is now worth around Rs 60.99. Looks like the RBI has intervened to sell dollars and buy rupees.
The article originally appeared on www.firstpost.com on July 8,2013.
 (Vivek Kaul is a writer. He tweets @kaul_vivek) 

Why gentlemen no longer prefer bonds

marilyn monroe & jane russell 1953 - gentlemen prefer blondes - by frank powolny
Vivek Kaul 
Gentlemen prefer bonds” is an old bear market saying. It essentially refers to a scenario where investors sell out of the stock market and invest their money into bonds, particularly government bonds.
But we live in ‘interesting’ times where investors are selling out of both bond markets as well as stock markets. The yield or return on the 10 year American treasury 
bond rose to 2.66% on June 24, 2013. The treasury bond is a bond issued by the American government to finance its fiscal deficit. Fiscal deficit is the difference between what a government earns and what it spends.
Investors have been selling out on the American treasury bonds. When a spate of selling hits the bond market, bond prices fall. But the interest that the government pays on these bonds till they mature, continues to remain the same, thus pushing up the return or the yield to maturity for those investors who buy these bonds.
The return or the yield on the 10 year American treasury bond has gone up at a very fast rate since the beginning of May. As on May 1, 2013, the return stood at 1.64%. Since then it has jumped by more than 100 basis points (one basis point is equal to one hundredth of a percentage) to 2.66%.
The first repercussion of this is that the borrowing cost of the American government will go up in the days to come. Any fresh bonds issued by the American government to finance its fiscal deficit will have to match the current return on a 10 year American treasury bond. In fact, between May 1 and June 24, the return on the 10 year American treasury bond has gone up from 1.64% to 2.66%. This is a rise of more than 62%, which will ultimately reflect in the borrowing costs of the American government.
But that is not the major reason for worry. The return on the 10 year American treasury acts as a benchmark for other interest rates, including those on home loans (or mortgages as they are called in the United States). So if the return on the 10 year American treasury is going up, then the interest rates on all kinds of loans goes up as well. This is because lending to the government is deemed to be the safest and hence returns on all kinds of other loans need to be higher than the return made on lending to the government.
This has led to the interest on the 30 year home loans rising by around 100 basis points(one basis point equals one hundredth of a percentage) 
to 4.4%, writes Mark Gongloff on The Huffington Post, website. This rise in interest rates means higher EMIs (equated monthly instalments) on home loans. “It is the biggest single move in interest rates since at least 1962, according to Dan Greenhaus, chief global strategist at the New York brokerage firm BTIG,” writes Gongloff.
A higher EMI could put the housing recovery in the United States in jeopardy and thus impact overall economic recovery as well. At higher interest rates people are less likely to borrow and buy homes. Less home buying could slow down the increase in home prices. As Gongloff points out “The surge in rates will likely squeeze mortgage refinancing and borrowing and could smother the recent rebound in the housing market, which has largely been driven by investors taking out cheap loans to buy cheap houses.”
Home prices in the United States have gone up by nearly 10.9% between March 1, 2012 and March 1, 2013, as per the Case-Shiller 20 City Home Price Index. A demand for greater homes creates jobs in the real estate and ancillary sectors. And more homes are likely to be bought at low interest rates than higher.
Low interest rates also get the ‘home equity’ loans going. Home equity is the difference between the market price of a house and the home loan outstanding on it. American banks give loans against this equity. People are more likely to borrow against this equity when interest rates and EMIs are low.
In fact, extraction of home equity became a very important driver of consumption in the United States in the years running up to the financial crisis which started in September 2008. As is the case with any advanced economy, consumption formed a major portion of the US GDP. Home equity loans were used to buy SUVs, furniture, other consumer goods or simply to pay off the debt that accumulated on other expensive forms of borrowing like the credit card.
Charles R Morris writing in 
The Trillion Dollar Meltdown: Easy Money, High Rollers, And the Great Credit Crash explains this phenomenon: “Consumer spending jumped from a 1990s average of about 67% of GDP to 72% of GDP in early 2007. As Martin Feldstein, a former chairman of the Council of Economic Advisers, has pointed out, that increase was financed primarily by the withdrawal of $9 trillion in home equity.” Feldstein’s study was carried out for the period between 1997 and 2006. Home equity supplied more than 6% of the disposable personal income of Americans between 2000-2007, another study pointed out. In fact, by the first quarter of 2006, home equity extraction made up for nearly 10% of disposable personal income of Americans.
But this is possible only when interest rates are low. With returns on 10 year treasury bonds rising, the interest charged on home equity loans is likely to go up as well. Hence, this means that people are less likely to borrow against their home equity. Also, with home loans becoming expensive the price of real estate is unlikely to continue to go up at the same speed as it has in the recent past, because Americans will now buy fewer homes. If home prices don’t rise, there is lesser home equity to extract. All this means less consumer spending which in turn will lead to slower economic growth.
The rise in bond yields or returns is essentially a reaction to the decision made by the Ben Bernanke led Federal Reserve of United States, the American central bank, to go slow on the money printing operations. The Federal Reserve has been printing $85 billion every month to buy both government and private sector bonds. By buying bonds it pumped the printed money into the American financial system. With enough money going around, the Federal Reserve managed to keep interest rates low encouraging people to borrow and spend.
But now it wants to change track. As Bernanke told the press on June 19, 2013 “
If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year…And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year.
Bernanke further said that “in this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7%, with solid economic growth supporting further job gains.”
Hence, if economic growth in the United States continues, the Federal Reserve will gradually slowdown and finally stop money printing by the middle of next year. The message that Bernanke wanted to give was two fold. One of course was the fact that the Federal Reserve would “taper” its money printing operations in the days to come. But the other more important message was that the Federal Reserve felt that strong growth was “finally” returning to the American economy.
But the markets (particularly the bond market) has bought only one part of the two-fold message from the Federal Reserve. The growth message clearly hasn’t gone through. The bond market has clearly come around to believe that the days of “easy money” will be soon coming to an end, as the Federal Reserve will stop its money printing operations.
This will lead to interest rates going up. Interest rates and bond prices share an inverse relationship. As interest rates go up, bond prices fall. And in the expectation of the interest rates going up and bond prices falling, investors are selling out of bonds, and thus driving up interest rates. 
As The New York Times reports “A bond sell-off has been anticipated for years, given the long run of popularity that corporate and government bonds have enjoyed. But most strategists expected that investors would slowly transfer out of bonds, allowing interest rates to slowly drift up.” That has clearly not happened.
In fact, Bernanke made it very clear that the Federal Reserve is only planning to slowdown and stop future money printing. It has absolutely no plans of withdrawing the money that it has already printed and put into the financial system. 
Or as Bernanke put it “akin to letting up a bit on the gas pedal.” “Putting on the monetary brakes would entail selling bonds out of the Fed’s portfolio, and that’s not happening any time soon,” Bernanke said.
But the bond market is already taking into account the Federal Reserve pumping out the money that it has printed and put into the financial system, in the days to come. As and when that happens, interest rates will rise sharply.
At a global level, it has meant a slowdown in the dollar carry trade. Interest rates on loans raised in dollars are going up, making it unviable for investors to borrow in dollars and go searching for high returns, all over the world. This has led to investors selling out from stock and bond markets across the world. And that is likely to continue in the days to come.
The article originally appeared on www.firstpost.com on June 25, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)