Is Risk Back On In The Bond Market?

Includes: DTYL, TIP, TLT
by: John M. Mason

On Monday morning, January 7, 2013 the 10-year U. S. Treasury bond was trading around 1.92 percent. This is up from a recent low of about 1.59 percent around December 5 and December 6, 2012. I can also be noted that the 10-year German bond was trading around 1.52 percent on January 7, up from around 1.30 percent around the December 5 through December 10 period in 2012.

The United States Treasury issues and the sovereign securities of Germany have been the haven for international investors attempting to avoid risk. Now, it appears as if there is some of the international investment money is moving back into riskier securities.

Ever since the beginning of the European debt crisis, this has been the general pattern of the movement of funds. If there is a substantial concern over the European situation, money moves from riskier assets into German bonds and into U.S. Treasury securities and the interest rates on these latter issues decline.

When European leaders (and I use that term lightly) seem to be moving in the right direction to lessen problems on the continent, funds move out of German governments and U.S. Treasury issues and go back into riskier assets. To have yields as low at 1.60 percent on 10-year bonds in the United States and around 1.30 percent with the same maturity in Germany is to see historical lows unseen before.

Now, we seem to be seeing these interest rates rise. The seeming cause of these increases is the agreements reached in Europe at the end of the last year. There is some confidence in the financial markets that the Economic Union is finally pulling things together and that there is some chance that the euro will be maintained and a banking union will be achieved along with a fiscal union of European nations.

The hope is that the Economic Union has actually achieved some progress on these sticking issues and is not just kicking the can down the road. We have been here before only to be disappointed. Yet, international investors seem to be putting more and more money behind their confidence in the movement that has been made.

The supporting evidence to the rise in United States and German interest rates is also present. In the United States, Treasury Inflation-Protected Securities (TIPS) have also rallied. This is another sign that risk-flight money is leaving these U.S. issues.

For example, the yield on 10-year TIPS was around a negative one percent in early December when the regular bond was so low, an all time low yield for these securities. The morning of January 7, these TIPS were trading to yield around a negative 0.67 percent.

Note that the spread between the 10-year bonds and the 10-year TIPS was roughly the same in each period so that the movement of these two yields has been parallel. This is a sign that the low yields on both of the securities were a sign that U.S. Treasuries had been receiving this risk-averse money. The confirming evidence that we see in Europe is the yield spreads between the 10-year German bond and other similar issues of European sovereign debt of lesser quality.

For example, the spread between the 10-year bond of Greece and the 10-year bond of Germany was 13.80 percentage points on December 5, 2012. The spread between the 10-year Portuguese bond and the 10-year German bond was 6.34 percentage points on December 6. And, the similar spread between Spanish bonds and German bonds was 4.29 percentage points on December 10.

On Monday, January 7, the similar spread between Greek bonds and German bonds was 9.71 percentage points, between Portuguese bonds and German bonds was 4.89 percentage points, and between Spanish bonds and German bonds was 3.57 percentage points. These spreads were the lowest attained in a long time.

The conclusion I draw from this is that risk-averse investors are now moving back into riskier securities. The feeling seems to be that the officials of the European Union are moving in the right direction, that this direction is sustainable, and that they can move back into the lesser credits of European sovereign debt in order to pick up badly needed yields.

If this is continues, longer-term United States Treasury yields will increase this year. How much will they increase?

My guess is that the yield on the 10-year TIPS will rise to at least zero! That sounds funny, but the negative yield has reflected the world's flight to quality. If most of the flight to quality is over then we should see TIPS moving toward positive territory. For the 10-year maturity this means that the rate will rise about 70 basis points. And, currently, the inflationary expectations built into the yield of U.S. Treasury securities seems to be around 260 basis points.

Thus, if the yield on the 10-year TIPS rises to about zero, then the yield on the 10-year Treasury bond should increase to about 2.60 percent during 2013. This 2.60 percent is up from the current market yield of around 1.90 percent. This is assuming that the investor's expectation for United States inflation does not rise from current estimates.

Of course, if the yield on the TIPS moves by more than 70 basis points, say, by around 100 basis points to provide a yield of a POSITIVE 30 basis points, you should see the 10-year Treasury yield move to a level much closer to 3.00 percent!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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