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The bond market is crashing - and it'll affect you

There are two very important trends unfolding in financial markets.

One is the surge in government bond yields, the other is the free-fall of the Australian dollar.

To the bond market first.

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In the US, bond yields – or interest rates – have jumped sharply since Donald Trump was elected President and he took the decision to lock in trillions of dollars of government borrowings to fund a range of tax cuts.

When Trump was elected, the 10 year bond yield in the US was around 1.9 per cent, with the 2 year yield around 1.0 per cent. Now, with the US budget being trashed and inflation pressures building, those yields have jumped to around 3.2 and 2.9 per cent, respectively.

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Part of this surge in yields is linked to the US Federal Reserve hiking interest rates in reaction to the extreme sugar hit to the economy from the extraordinary fiscal policy easing. It is also engaging in quantitative tightening, which is unwinding the money printing that was instigated in the wake of the banking crisis.

The other part of the jump in US yields is linked to expectations of an inflation surge as the economy is flooded with borrowed government money.

Rising bond yields matter. They increase the cost of borrowing not only for governments, but for business and consumers. At a time when the US economy is at risk of a slowdown, a further sharp rise in yields risk derailing business investment and household spending into 2019.

The rise in US and global bond yields had already impacted on the Australian economy.

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The recent rise in mortgage interest rates from most of the banks was linked in part to the rise in the cost of funds – that is, the price banks have to pay to raise capital to on-lend into the Australian market.

There is some risk that as the US bond market sells off further, there will be additional pressure on the banks to lift local interest rates, even if the Reserve Bank of Australia leaves official rates on hold.

The rise in US yields at a time when official interest rates are on hold and the domestic economy is on a knife-edge, is undermining the Australian dollar. Having peaked around 81 US cents earlier in the year, it has falling steadily to be holding now just above 70 US cents. If there is any further signs of economic softness into 2019, as seems likely with house prices falling away, the interest rate differential to the US would guarantee a break below 70 US cents and a move to 65 US cents would likely become the new consensus view.

At 70 US cents, the Aussie dollar is at its lowest since early 2016 and is just 2.5 US cents from slumping to the low levels reached during the global financial crisis.

For the moment, the fall of the dollar has been orderly. There is no currency ‘crisis’ and its weakness against other currencies, such as the Euro, yen and pound, have been more measured than the fall against the US dollar.

But if the US bond yields keep rising and yields in Australia remain low in line with the softer economy, the Australian dollar could come under considerable pressure.

65 US cents might be a conservative forecast for the near term.

If things get ugly and the US bond market keeps selling off, the Australian dollar could fall even further.