FX International Payments
By Frances Coppola
International businesses – even those that have no interest in bonds – may wish to take note, because such a change could, in theory, mean higher borrowing costs and a strengthening dollar exchange rate. That's because U.S. Treasury (UST) bond yields are linked with long-term interest rates, which in turn influence the direction of currency exchange rates. So, if bond yields are about to embark on a long-term rising trend, what could this mean for businesses exposed to exchange rate risk?
The yield on a bond is inversely correlated with its price. A bond is effectively a tradable interest-bearing loan. Its annual yield is its annual interest rate (or "coupon") divided by its market value. So, if an investor buys a newly issued $1,000 10-year bond with a 10 percent coupon, and holds it to maturity, the investor's return is 10 percent (10 percent coupon per annum is $100, divided by $1,000 = 10 percent). But if the investor sells the bond after 5 years, at a discount of 10 percent (i.e., for $900), the new holder's annual yield for the remaining 5 years until the bond's maturity will be $100 / $900 = 11.1 percent. Discounting the price thus raises the yield (which is the mathematical mechanism behind the inverse correlation).
Normally, the market price of a bond is below its "par value," i.e. the amount it will repay at maturity, reflecting the risk that investors take by lending money over a long period. The longer the time to maturity, the higher the investor's risk of loss. Thus, generally speaking, the closer the bond is to maturity, the higher its price will be and thus the lower its yield. Plotting bond yields against bond maturities on a graph creates a curve known as the "yield curve."3
In turn, bond yields influence coupon rates. The coupon rate is a measure of the bond's risk to an investor. If a bond is issued with a coupon significantly above current market yields for similar bonds, it is regarded as high risk and must be deeply discounted to attract buyers; similarly, if a bond is issued with a low coupon, it must be priced at a premium. Most bond issuers prefer to set coupon rates at around the market yield at the time of issue.
If there were a sustained rise in USD-denominated bond yields, therefore, interest rates on USD-denominated bonds could also rise, raising the cost of borrowing for U.S. corporations and for non-U.S. corporations that need dollars for international trade. As borrowing from banks is an alternative to issuing bonds, banks might respond to rising bond interest rates by raising interest rates on loans.
Higher borrowing costs in USD, but not in other currencies, encourages companies to borrow in other currencies and swap into USD. And it also encourages the growth of carry trades. Both of these tend to strengthen USD relative to the currencies on the other side of the trade. However, some economists are concerned that if a bond bear market does come, it may flout economic theory – which seems to have been often flouted since the Great Recession – and the USD currency exchange rate could weaken, rather than strengthen.
In a bull market, the price of an asset rises over the long-term. So, in a bond bull market, bond prices rise and, due to that inverse correlation, yields fall. If the bull market is sustained, then interest rates also fall. Many people think the very low interest rates of recent years are due to Federal Reserve interest rate policy and quantitative easing. But historical data shows that interest rates on U.S. Treasury bonds have been on a downward trend since the early 1980s.4
Yields on all other USD-denominated bonds have also fallen, in line with USTs. This is because USTs, which are guaranteed by the U.S. government, are the lowest-risk bonds and therefore command the highest prices. Other USD-denominated assets are priced at a discount to USTs, reflecting their higher risk, and thus have higher yields. When UST prices rise, the risk of the other bonds does not increase, so their prices rise in line with USTs, and their yields correspondingly fall. Interest rates on all USD-denominated bonds have been falling for over 30 years.5
In a bear market, the price of the asset falls over the long-term and the yield correspondingly rises. If it is sustained, then interest rates rise, raising the cost of borrowing for corporations. Bear markets can be associated with slowing economic growth and rising unemployment, as corporations reduce investment due to high interest rates. When this happens, the currency exchange rate can fall. Both interest and exchange rates can become more volatile, too, as investors faced with economic uncertainty look for "safe havens." Bear markets are often characterized by sudden sharp price swings.6
So a bear market in USD-denominated bonds could mean a strengthening USD exchange rate. Or it could cause the USD exchange rate to fall. Either way, rising economic uncertainty could increase exchange rate volatility.
This uncertainty could be worsened by changing opinions of interest rates. Rising interest rates are traditionally thought to indicate a worsening economic outlook, particularly for inflation. But in recent years, some economists have questioned this,7 and some analysts have even suggested that higher interest rates would benefit the economy.8
A bear market in USD-denominated bonds could be positive or negative for international businesses, depending on which way the USD exchange rate moves. If bonds denominated in other major currencies also entered a bear market, there might be little effect on the dollar. However, the European Central Bank and the Bank of Japan are still maintaining negative interest rates and actively reducing sovereign bond yields with quantitative easing. Bear markets in euro and yen denominated bonds could therefore be unlikely, which might imply that the USD exchange rate could strengthen relative to these currencies.
That said, as of January 2018 the USD exchange rate was falling against both these currencies despite rising interest rates.9 This continues the downward trend that was evident for much of 2017. It may be that the relationship between interest rates and currency exchange rates is more complex than economic theory suggests.10
If USD-denominated bonds are entering a bear market, businesses may experience higher borrowing costs. However, the effect on currency exchange rates is much harder to predict; the USD exchange rate could rise as higher interest rates attract investors and spark carry trades, or it could fall if rising interest rates cause the U.S. economy to slow. Businesses may wish to evaluate strategies for managing higher FX volatility and economic uncertainty.
With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “One Chart That Says The Bond Bull Market Is Over,” Forbes; https://www.forbes.com/sites/robisbitts2/2017/12/19/one-chart-that-shows-the-bond-bull-market-is-over/
2. “Bill Gross Calls A Bond Bear Market After Treasury Yield Surges,” Bloomberg; https://www.bloomberg.com/news/articles/2018-01-09/u-s-10-year-yield-climbs-as-boj-action-spurs-exit-speculation
3. “Yield Curve,” Investopedia; https://www.investopedia.com/terms/y/yieldcurve.asp
4. “3-month T-bill yield,” and “10-year T-bill yield,” FRED Economic Data; https://fred.stlouisfed.org/series/TB3MS; and https://fred.stlouisfed.org/series/DGS10
5. “Moody’s AAA-rated,” and “Moody’s BAA-rated,” FRED Economic Data; https://fred.stlouisfed.org/series/AAA; and https://fred.stlouisfed.org/series/BAA
6. “Digging deeper into bull and bear markets,” Investopedia; https://www.investopedia.com/articles/basics/03/100303.asp
7. “Does slower growth imply lower interest rates?” Federal Reserve Bank of San Francisco https://www.frbsf.org/economic-research/publications/economic-letter/2014/november/interest-rates-economic-growth-monetary-policy/
8. “7 benefits of a Federal Reserve interest rate hike,” BankRate; https://www.bankrate.com/banking/federal-reserve/7-surprising-benefits-of-higher-interest-rates-from-the-federal-reserve/
9. “Dollar’s weakness unsettles central bankers,” Financial Times; https://www.ft.com/content/23dbe094-fb79-11e7-9b32-d7d59aace167
10. “Covered Interest Parity,” Investopedia; https://www.investopedia.com/terms/c/covered-interest-rate-parity.asp