The Phantom Threat of US Bond Yields

Three months ago, 10yr US government bond yields were a little over 1.7%, today they are at 2.4%, with the capital risk premium (measured as 10yr nominal minus 10yr TIPS) and the Fed-calculated term premium both trend up out of zones they have occupied since mid-2015.  What threat does this rise in interest rates pose to consumers and corporates, and hence to short-to-medium term GDP prospects?  Last week saw the release of 3Q US flow of fund tables, which sketch the state of financial vulnerability of both  household and corporate sectors.  

For the corporate sector, gross financial liabilities rose 5.3% yoy to $25.1tr in 3Q, with bond liabilities up 7.2% to $5.1tr and bank loans up 6.5% to $7.57tr – all growing significantly faster than the 2.8% growth in nominal GDP in the 12m to September. However, corporate financial assets also grew faster than GDP< rising 6.6% yoy to $24.6tr.  As a result, the net borrowing from banks rose only 4.7% yoy to $6.57tr, and the net liability to credit markets excluding banks rose only 5.7% to $4.94tr.  Overall, by September 2016, the corporate sector had net liabilities to banks and credit markets of $11.65tr, up 5.1% yoy and equivalent to 60.8% of GDP.  As the chart below shows, although this ratio is in the upper end of the historic range, it is signficantly lower than pre-crisis levels, and lower than the levels sustained in the late 1980s. Moreover, the proportion has been in gentle decline over the last two quarters.  

But whilst the net debt/GDP ratio is relatively high, the historically low bond yields mean that the level of interest payments on this net debt relative to GDP during 3Q was very near an all-time low, and was equivalent to just 1% of GDP. This proportion has been lower only briefly, in 2012.  Even with yields rising to 2.4%, the ratio of interest payments to GDP rises only to 1.4% of GDP – still within the normal range seen during the post-crisis ‘new normal’.  It seems a surprisingly small impact from what has felt like a large bond-market move. 

For the household sector, the underlying assumptions must be different, because one of the legacies of the financial crisis has been that households have deleveraged sufficiently to regain a net positive position with banking and credit markets. On a net basis, then, the household sector’s cashflow situation stands to be improved by the rise in bond yields. At the height of the crisis, the houshold sector had net debts with the banks and credit markets of $2.7tr.  A reliable net credit position was restored in 2012 and has been maintained since. In September 2016, the net asset position stood at $461bn.  Although this was down $348bn yoy, this mainly reflected a move out of bonds (holdings down by $603bn but offset by a $737bn rise in deposits), and was more than compensated by a $1.25tr rise in equity holdings. Overall, the  household sectors net financial position improved by $3.23tr, or by 5.9% yoy, to net assets of $58.23tr.  

Conclusion?  For now, the rise in bond yields looks unthreatening for both the corporate and household sector’s finances, and consequently for short to medium term GDP prospects.