U.S. Economy at Greater Risk if Rate Hikes are Delayed

Recently, U.S. Treasury yields have not been aligning with oil price trends. In the early stages of past wars, oil prices and interest rates tended to rise together, but currently, Treasury yields are not falling even when oil prices decline. This raises questions about whether the bond market is solely moving based on oil prices.

Dr. Kim Hyo-jin emphasized market uncertainty, stating, "Lately, I'm very suspicious about whether the U.S. bond market is trading based on oil prices."

Changes in the probability of interest rate hikes, often featured in market news, do not align with actual movements in Treasury yields. Dr. Kim Hyo-jin pointed out, "There isn't much difference in U.S. interest rates when the probability of a hike is 70% compared to when it momentarily dropped to 30%." This suggests that the bond market does not merely reflect hike/cut probabilities in its pricing but considers other factors more significantly.

When applying the Taylor Rule, the appropriate interest rate for the current strength of the U.S. economy is approximately 5.1%. Dr. Kim Hyo-jin explained, "The Taylor Rule also shows that the rate matching the current U.S. economic strength is 5.1. So, around 5% would be the rate matching the current U.S. economy. That explains why people might say it could go to 5%." This means that U.S. Treasury yields reaching 5% is not an unusual phenomenon, and anything above 5% could be a turning point where economic burden and shock may occur.

Dr. Kim Hyo-jin stated, "From my perspective, the point of this chart isn't really about needing to sell stocks because it could go to 5%. Rather, the key message is that there are quite a few upward pressures pushing rates higher, beyond the consumer prices we're currently seeing. So, it will be difficult for rates to stabilize smoothly and quickly." This suggests that factors beyond simple inflation metrics are hindering rate decreases.

Unlike in the past when it was confined to specific items, this broad inflation is recognized as a structural problem that will be difficult to resolve.

Over the past five years, the U.S. inflation level has risen by approximately 20% compared to historical trends. Dr. Kim Hyo-jin warned, "If you calculate how much inflation has risen above the old trend over the past five years, it's about 20%. The longer interest rate hikes are delayed, the more we'll be needing a spade for what a hoe could have fixed." This means that delaying rate hikes will likely require greater costs and more aggressive tightening policies in the future.

The current high inflation levels are not easily reduced due to downwardly sticky factors such as significantly increased wages since the pandemic, further highlighting the necessity of interest rate hikes.

Dr. Kim Hyo-jin stated, "If I had a choice, I would think a hike would be very clean." Prolonged uncertainty could have a greater negative impact on the market, and it is crucial to raise interest rates to control the absolute level of inflation.

The recent period of interest rate hikes from 2022 to 2023 is considered an exceptional case where stock prices fell sharply after rate increases. Dr. Kim Hyo-jin pointed out, "The more interest rates rose, the more stocks kept falling. And Korea's fell the most." He noted that in the mid-2000s or mid-2010s, stock prices tended to rise after a gradual period of adjustment in the early stages of rate hikes. Due to this intense recent experience, the market instinctively perceives interest rate hikes with fear.

Therefore, there is an argument that prompt interest rate hikes at this point could help prevent greater future risks.

This situation could pose a severe long-term threat to U.S. fiscal health.

Dr. Kim Hyo-jin stated, "It seems to be true that to absorb this, increasingly higher interest rates must be paid, which is the phenomenon we are witnessing." With declining bid-to-cover ratios for Treasury bonds and investors' selective purchasing, the U.S. government faces increasing fiscal pressure to pay higher interest rates to issue and absorb Treasury bonds.

This acts as a factor amplifying concerns about the sustainability of U.S. finances.

The 5% U.S. Treasury yield was already a psychologically anticipated resistance level in the market, but the current rate increase is not a temporary surge but a steady rise in monthly averages. Dr. Kim Hyo-jin pointed out the complex issues, stating, "Because if it spikes, there would be a reason for the spike, and if that reason disappears and is fixed, U.S. Treasury yields would just come down. But if you look at the monthly average, you see seven or eight consecutive upward trends, making people think, 'Is this really a fiscal problem? Is inflation a problem too? There are so many problems, so am I wishing for too happy a scenario where all of them get resolved?'"

The perception is growing that it's realistically difficult for all problems to be resolved simultaneously, given too many variables to address, such as fiscal issues, inflation, and hyperscaler funding demand.

Based on this experience, it is highly unlikely that the U.S. will undertake fiscal tightening.

The U.S. has resolved economic crises not through orthodox fiscal tightening or interest rate adjustments, but by artificially creating demand for Treasury bonds when lacking. Dr. Kim Hyo-jin said, "When considering how the U.S. resolves problems, it ultimately does so by creating demand." In the past, financial authorities have, for example, changed liquidity ratio regulations to encourage banks to purchase Treasury bonds.

This suggests that despite deteriorating fiscal health, the U.S. government can secure demand for Treasury bonds through policy measures if necessary.

Currently, approximately $8 trillion is accumulated in Money Market Funds (MMFs), reaching an all-time high. However, since these funds are mostly managed with short-term instruments, they do not directly flow into the long-term Treasury market. Dr. Kim Hyo-jin explained, "Recently, U.S. MMFs are around $8 trillion, which is a record high. But because they only operate short-term, that impact doesn't reach long-term instruments; it just circulates within the short-term market."

This explains why demand in the long-term Treasury market remains insufficient despite massive liquidity.

This suggests that current debt crisis theories are also likely to follow past patterns.